Wall Street’s Uncertain Horizon: Record Valuations Signal Potential Downturn
Last week was a significant one for Wall Street. On Monday, Jan. 20, Donald Trump was sworn in for his second nonconsecutive term as president. During his first term (Jan. 20, 2017 – Jan. 20, 2021), the Dow Jones Industrial Average (DJINDICES: ^DJI) rose by 57%, the S&P 500 (SNPINDEX: ^GSPC) increased by 70%, and the Nasdaq Composite (NASDAQINDEX: ^IXIC) soared by 142%.
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S&P 500 Sets New Record High
On Jan. 23, the S&P 500 closed at a new record high of nearly 6,119, rebounding quickly from a prior 5% dip. This trend can excite investors, but it also indicates potential trouble as the current bull market approaches troubling territory.
Market Valuations Near Rare Levels
While many economists focus on the risk of a U.S. recession, a significant yield-curve inversion, and a noted decrease in the U.S. M2 money supply, the stock market quietly approaches an unusually high valuation. The S&P 500’s Shiller price-to-earnings (P/E) ratio, also known as the cyclically adjusted P/E ratio (CAPE ratio), reveals this trend.
Unlike traditional P/E ratios, which rely on recent earnings data, the Shiller P/E provides a broader view, using the average inflation-adjusted earnings over the last ten years. This helps eliminate distortions from sudden changes in earnings.
S&P 500 Shiller CAPE Ratio data by YCharts.
As of Jan. 23, the S&P 500’s Shiller P/E stood at 38.59, just below its peak of 38.89 recorded in December 2024. This figure is on the verge of exceeding 39, something that has happened only two other times in history since 1871, with the previous highs reaching 40 in January 2022 and 44.19 in December 1999.
Historically, the S&P 500’s Shiller P/E has averaged around 17.2 over the past 154 years. This suggests that the current valuation is 124% above the historical average. These high valuations have often preceded significant market declines.
Historical Patterns Indicate Caution
The Shiller P/E has surpassed 30 only six times since 1871, including now. After each of these instances, the major indexes lost between 20% and 89% of their value. While this ratio does not predict the timing of downturns, it suggests that high valuations often accompany trouble.
Image source: Getty Images.
Understanding Market Corrections
Given these insights, it appears likely that the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite could drop in the near future. However, this isn’t necessarily bad news for long-term investors. The markets naturally oscillate between gains and losses, making corrections, bear markets, and crashes relatively common occurrences.
For long-term investors, history shows that downturns often lead to opportunities. Although the timing of these events is unpredictable, the markets historically recover and reach new heights.
^DJI data by YCharts.
Additionally, research by Bespoke Investment Group indicates that bear markets tend to last around 286 days on average, while bull markets last around 1,011 days. This illustrates that corrections, while necessary, do not last long compared to the periods of growth.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
