The Stock Market Is Doing Something It Has Done Only 2 Times Since 1985, and History Is Clear About What Happens Next

The S&P 500(SNPINDEX: ^GSPC) is widely regarded as the best gauge for the entire U.S. stock market. The index has returned 27% year to date in one of its strongest performances of the 21st century. But warning signs are starting to appear.

In November, a Conference Board survey found that 56.4% of U.S. consumers expect the stock market to rise over the next year, the highest reading on record. That may sound like good news, but Morgan Stanley sees it as a contrarian indicator signaling irrational optimism at a time when valuations are stretched.

Indeed, the S&P 500 recently attained a valuation only seen during two other periods since 1985, and the benchmark index eventually crashed after both incidents. Read on to learn more.

The S&P 500 is historically expensive,

The S&P 500 currently has a forward price-to-earnings (PE) ratio of 22.3. That is a material premium to the five-year average of 19.7 times forward earnings and the 10-year average of 18.1 times forward earnings. The stock market has not been so expensive since April 2021, according to FactSet Research.

In fact, the S&P 500 has only reached a forward PE ratio above 22 during two periods since 1985. The first time was the dot-com bubble. The forward PE multiple drifted above 22 in 1998 and generally stayed above that level for about three years. The S&P 500 ultimately declined 49% after peaking in March 2000.

The second time the forward PE ratio topped 22 was the Covid-19 pandemic. Investors underestimated how profoundly supply chain disruptions and stimulus spending would impact the economy, and they bid many stocks to absurd valuations. After peaking in January 2022, the S&P 500 eventually declined 25% amid the fiercest inflation wave in 40 years.

To summarize, the S&P 500 has traded above 22 times forward earning during just two periods since 1985, and the index (eventually) fell sharply both times. Of course, forward PE multiples are prone to inaccuracy because they are based on earnings estimates. But we can consider the current PE ratio (calculated using trailing-12-month earnings) to solve that problem.

Currently, the S&P 500 trades at 28.7 times earnings. That is a significant premium to the five-year average of 24.1 times earnings and the 10-year average of 21.9 times earnings. And dating back to 1990, the S&P 500 has never generated a positive 10-year return when the initial PE multiple exceeded 25, according to LPL Research.

A silver lining for investors

In October, Goldman Sachs updated its 10-year outlook for the S&P 500. Analysts expect the benchmark index to generate a total return of 3% annually during the next decade. That is well below the long-term average of 11% annually. But the report included an important silver lining for investors.

While Goldman attributed its gloomy outlook to historically high valuations, a handful of companies are the primary culprits. “The premium valuation for the top 10 stocks is the largest since the dot-com boom in 2000,” analysts wrote. That means the other 490 stocks are priced more attractively, which itself implies more upside.

Consequently, Goldman analysts estimate an equal-weight S&P 500 index fund will return 8% annually in the next decade, beating the traditional S&P 500 (which is weighed by market capitalization) by 5 percentage points per year. That prediction reflects their belief that the 10 largest stocks will struggle to outperform in the coming decade.

Here is the bottom line: The S&P 500 currently trades at a historically expensive forward PE multiple, which means investors should be particularly cognizant of valuations when buying stocks in the current market environment. Also, now is a good time to accumulate a little extra cash. Doing so will make it easier to capitalize on the next correction or bear market.

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