The S&P 500's Shiller CAPE ratio has climbed to 40, closing in on the level it reached just before the 1999 dot-com bubble burst. The index has still gained 70% over the past three years, but the elevated ratio signals valuations are stretched well beyond their historical norm.
The S&P 500 is trading at a Shiller cyclically adjusted price-to-earnings (CAPE) ratio of 40, nearing the all-time high the metric set in 1999 just before the dot-com bubble burst. The CAPE ratio, which weighs current prices against ten years of inflation-adjusted earnings to smooth out short-term swings, sits far above its historic average of around 17.
Index gains outpace historical norms
The warning comes after a strong multi-year run. The S&P 500 has risen 70% over the past three years, while the Dow Jones Industrial Average gained 50% and the Nasdaq Composite climbed 89% over the same span. A high CAPE ratio does not mean a crash is inevitable, but it does indicate valuations are much higher than they have historically been, and the stock market eventually experiences a pullback when that happens.
Timing the market carries its own risk
Exiting the stock market to avoid a pullback carries its own risk, according to the analysis, since no one consistently gets the timing right. JPMorgan Chase research shows that over the past two decades, seven of the ten best trading days occurred within two weeks of the ten worst days. As a result, investors who pull money out during downturns risk missing the sharpest rebounds that often follow close behind.
Rather than exiting entirely, adjusting a portfolio to reduce concentration in richly valued sectors is one way investors might manage the risk the elevated ratio points to.
Source: The Motley Fool
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