The S&P 500 Is Pushing Its Limits!

Last quarter, I wrote that U.S. stocks were priced to deliver a negative 0.3% over the next eight years, based on the cyclically-adjusted price/earnings ratio (“CAPE”). Another quarter in, and not much has changed!

In March, the S&P 500 was trading at a CAPE of 27.0. Today, the number is 26.9. And our expected annual return over the next eight years is still -0.3%. Here’s the chart for reference:

CAPE chart S&P 500

This comes as no surprise. The past six months have seen flattish earnings growth and a stock market that has traded in a narrow range. Still, this deserves repeating: At a CAPE of 26.9, the S&P 500 is very expensive by historical terms. It’s not quite at “bubble” levels — just look at that one peak on the chart running through the late 1990s! But how many other green peaks do you see crossing that red line?

Not many. And we’re pushing that line today.

Bear in mind: CAPE is a relative indicator, like all valuation metrics. It compares the current stock or index price to the average earnings of the past ten years. Other indicators compare cash flow, sales (as John did earlier this year), or the current year’s earnings. That said, stocks can shoot a lot higher, and the P/E ratio along with it, if earnings or sales drop like a rock.

That’s what value investors should be concerned about — we don’t want this indicator to push into bubble territory.

We’d have to see several years of above-average earnings growth for the market to grow into its multiple and justify the levels we’re seeing today. And sure, anything’s possible, but given the highs to which corporate profits have climbed in recent years, and the fact that recessions often follow these highs, I believe we’re in store for a correction.

A buy-and-hold investor in an S&P 500 index fund shouldn’t expect much for the next several years. Starting at today’s levels, they’d be lucky for it to trade in a range-bound market. More likely, it’ll shoot down in a breakout direction leaving these investors feeling sore.

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Charles

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About Author

Charles Sizemore is a research analyst with Dent Research. His primary research focuses on income, retirement strategies and fundamentals.