The S&P 500's warning signal, and why it's worth paying attention to

The stock market has been on a fantastic ride over the past several years. The S&P 500 (^GSPC -0.31%) is up 70%, the Dow Jones Industrial Average (^DJI -0.11%) has risen 50%, and the Nasdaq Composite (^IXIC -0.31%) has gained an impressive 89% over the past three years. What’s not to like, right?

The problem is that the S&P 500 is flashing a warning signal that it hasn’t shown since the dot-com bubble burst. The artificial intelligence boom is causing many stock valuations to skyrocket, pushing them to heights never seen before. And some people are worried that it won’t be long before the music stops and investors are left without a seat.

Here’s what you should know if you’re trying to avoid such a scenario with your investments.

The S&P 500’s warning signal, and why it’s worth paying attention to

One of the clearest warning signals coming from the S&P 500 is the rising Shiller cyclically adjusted price-to-earnings (CAPE) ratio. The CAPE ratio compares current stock prices to 10 years of inflation-adjusted earnings.

The goal of the metric is to provide a ratio that smooths out short-term stock volatility and gives investors a longer-term perspective on whether stocks are overvalued.

The problem right now is that the CAPE ratio for the S&P 500 is nearing the all-time high it set in 1999 — just before the dot-com bubble burst. The CAPE ratio is currently 40, far above its historic average of around 17.

S&P 500 Shiller CAPE Ratio data by YCharts.

A high CAPE ratio doesn’t mean a stock market crash is inevitable. But it is a clear indicator that stock valuations are much higher than they have been historically. When that happens, the stock market eventually experiences a pullback.

The best action to take right now to protect your portfolio

History shows that even with a warning signal in the S&P 500, your best course of action right now is probably to… do nothing.

That sounds a bit passive and certainly counterintuitive, but the problem with trying to time the market is that no one is good at it. And even if you were successful in pulling your money out at the right time, it’s highly unlikely that you’d put your money back into the market at the right time.

JPMorgan Chase research shows that over the past two decades, seven of the 10 best days in the market occurred within two weeks of the 10 worst days. And, because none of us knows when that’s happening, if we take our money out of the market during the bad times, we’re almost guaranteed to miss out on the best days.

If you must act, adjusting your portfolio to reduce risk could be a good move. For example, if you’ve bought too many AI stocks over the past several years, rebalancing that with investments in other sectors or buying an S&P 500 index fund could help spread out your risk.

But the important part to remember is that no one knows where the top or bottom of the market is. And taking your money out is a sure way to miss out on future returns.