Key Points
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The Shiller P/E ratio provides perspective on how expensive the S&P 500 is.
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The Shiller P/E ratio hasn’t been this high since the height of the dot-com bubble.
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Investors are better off staying invested for the long term than trying to time the market.
A common saying I’ve heard throughout my life is that history repeats itself, and the stock market is no exception. Some cycles are fairly frequent, while others are much rarer. Right now, we’re approaching one that falls into the latter bucket, with a stock market that hasn’t been this expensive in over 26 years.
There are various ways to measure how expensive the stock market is (based on the S&P 500(SNPINDEX: ^GSPC)), but one go-to is the Shiller price-to-earnings (P/E) ratio, also known as the cyclically adjusted P/E ratio (CAPE ratio). At the time of writing, the CAPE ratio was 42.2, its highest level since the dot-com bubble when the ratio peaked at 44.2 in November 1999.
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Unfortunately, the dot-com bubble didn’t end well, but what does that mean for the current state of the stock market? Well, let’s take a look.
What the CAPE ratio tells you
The CAPE ratio is a useful metric because it puts into perspective how much you’re paying for each dollar of earnings from S&P 500 companies. It looks at S&P 500 companies’ earnings over the past 10 years and adjusts them for inflation, removing one-off events (such as the COVID-19 lockdown) that could skew the numbers.
The higher the CAPE ratio, the more expensive the S&P 500 is considered. With the average CAPE ratio since the start of 1990 at just over 27, that should show you just how expensive the current market has become. It’s not a flawless metric by any means, but it’s good for providing historical context.
S&P 500 Shiller CAPE Ratio data by YCharts. CAPE ratio on the chart is as of the end of July.
How the present compares to the dot-com bubble
The dot-com bubble was one of the most speculative periods in stock market history, mainly driven by investors carelessly throwing money at unproven internet businesses. At the peak of the dot-com bubble in March 2000, the S&P 500 peaked at 1,527 points (that’s how indexes are measured). Over the next 2.5 years or so, it would lose 50% of its value, leaving many companies bankrupt and many investors with tons of losses.
Although the CAPE ratio is approaching dot-com bubble levels, this isn’t quite an apples-to-apples comparison. Many of the companies during the dot-com bubble didn’t have meaningful revenue, let alone profit. That’s far from the case right now, with much of the stock market’s expensiveness driven by the current artificial intelligence (AI) boom and the skyrocketing valuations of big tech.
Right now, the S&P 500 is heavily concentrated in the “Magificent Seven” stocks, which investors are willing to pay a premium for. There are arguments about whether the current AI craze is a bubble, but the top companies driving it are far from as speculative, unproven, or unprofitable as those during the dot-com bubble.
Image source: Getty Images.
What investors should do
The most important thing to remember is that past results don’t guarantee future performance. Just because the last time ended badly doesn’t mean that it’ll happen again. Assuming the same will happen and trying to time the market (i.e., selling stocks in anticipation of a drop) can be counterproductive.
As the old saying goes, “Time in the market beats timing the market.” One of the best things that investors can do is to stay invested and trust that, even if (more so when) the market experiences a pullback or correction, it’ll bounce back and produce good long-term returns.
Of course, this is easier said than done, which is why I typically recommend that investors take a dollar-cost averaging approach to investing right now. With dollar-cost averaging, you decide on a specific amount you can invest, set an investment schedule, and stick to it regardless of market conditions.
Whether it’s weekly, biweekly, monthly, or whatever frequency works for you, dollar-cost averaging helps you resist the urge to time the market because your investing schedule is already set. Investors who consistently stay invested for the long haul typically come out ahead of those who try to time the market.
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Stefon Walters 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.