The Stock Market Is Doing Something for Only the 3rd Time in 156 Years — and if Historical Precedent Is Accurate, the S&P 500 May Be Headed for Disaster
Through Oct. 28, the S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC) have both climbed about 12% on the year. Meanwhile, the more conservative Dow Jones Industrial Average (DJINDICES: ^DJI) has increased 9.5%.
Much of this momentum can be traced to the artificial intelligence (AI) revolution. Trillions of dollars are being poured into data centers, demand for semiconductors and related infrastructure is accelerating, and earnings growth across a variety of sectors is pushing stocks toward record highs.
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But beneath the market’s euphoria, an important valuation indicator is flashing a warning. Historically, when this indicator reaches a certain threshold, the stock market eventually experiences a correction or bear market.
Here’s what history tells us — and why investors shouldn’t necessarily panic.
The stock market is approaching dangerous territory
One of the more interesting ways to measure stock market valuation is the cyclically adjusted price-to-earnings (CAPE) ratio, popularized by Nobel Prize-winning economist Robert Shiller. Unlike a conventional price-to-earnings (P/E) multiple, which compares stock prices with earnings over a single year, the CAPE ratio uses average inflation-adjusted earnings over the preceding decade. Using a long-term dataset helps smooth out temporary fluctuations in profitability.
The CAPE ratio has been backdated using roughly 156 years’ worth of stock market data. Economists found that it averaged roughly 17.8. As of this writing (Oct. 29), the indicator stands at 40.7, more than twice its historical average. To put this into perspective, there are only two other times when the CAPE ratio exceeded 30 for a prolonged period.
Shiller CAPE Ratio data by YCharts.
In September 1929, the CAPE ratio reached 33 shortly before the Wall Street crash ushered in the Great Depression. During this period, the Dow Jones lost 89% of its value between its 1929 peak and 1932 trough.
During the dot-com bubble, the CAPE ratio eclipsed 30 in 1997 and continued climbing, eventually exceeding 44 (its all-time high) in December 1999. The S&P 500 went on to lose 49% between March 2000 and October 2002, while the Nasdaq plunged nearly 78%.
While these episodes illustrate why elevated valuations deserve attention, they also reveal an important limitation: Stocks can, and often do, remain expensive for years before a major downturn. Think of it this way: An investor who sold everything when the CAPE ratio first exceeded 30 in 1997 would have missed out on further valuation expansion before the dot-com bubble finally burst.
Investors are using other people’s money to buy stocks
Another data point to be aware of during this seemingly unstoppable bull market is that investors are borrowing extreme amounts of money to buy stocks. This is a practice known as margin trading.
According to the Financial Industry Regulatory Authority (FINRA), outstanding margin debt reached $1.48 trillion in September. Per the graph below, margin debt has risen 130% since November 2022 when the AI revolution started gaining momentum following the commercial launch of ChatGPT. What’s even more striking is the pace at which margin debt is accelerating!
FINRA Margin Debt data by YCharts.
Since the AI boom began in late 2022, enthusiasm surrounding companies such as Nvidia, Microsoft, Amazon, Alphabet, Meta Platforms, Broadcom, and Palantir Technologies has propelled the broader market higher.
Borrowed money will amplify investment returns during a bull market, but leverage works in both directions. This means that when stock prices decline, investors trading on margin may be required to deposit additional funds or liquidate positions to pay their lenders. These forced sales accelerate market downturns, particularly when many investors collectively hold the same concentration of companies.
History offers an important reason to remain optimistic
There’s an important nuance in recognizing that the stock market is historically expensive and actually knowing when stocks will crater. In the long run, corrections and bear markets are inevitable. At the end of the day, the CAPE ratio does not tell investors when the next sell-off will happen.
Nevertheless, there’s a historical pattern worth remembering. The grey columns in the chart below represent U.S. recessions in modern history. Notice that the S&P 500 repeatedly recovered from downturns and eventually reached new all-time highs.
After the dot-com bubble burst, the S&P 500 eventually surpassed its previous peak by 2007. The financial crisis of 2008 sent the index tumbling 57%, yet the market recovered and established new highs in 2013. More recently, the S&P 500 witnessed a brief pandemic-driven bear market in 2020 and another significant decline in 2022. In both instances, the index recovered and went on to establish fresh records.
This pattern reinforces an important lesson about long-term investing. The stock market’s history is filled with recessions, financial crises, geopolitical conflicts, and speculative bubbles. Yet the S&P 500 always adapted as companies increased earnings, ultimately proving the index’s resilience and reputation as a source of wealth creation.
The biggest risk isn’t that another bear market is coming. It’s making a hasty, emotionally charged investment decision based on a downturn whose timing no one can reliably predict. For investors with long time horizons, maintaining a diversified portfolio, avoiding excessive leverage, and continuing to invest through market volatility will ultimately prove more profitable than attempting to time the next crash.
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Adam Spatacco has positions in Alphabet, Microsoft, Nvidia, and Palantir Technologies. The Motley Fool has positions in and recommends Alphabet, Broadcom, Meta Platforms, Microsoft, Nvidia, and Palantir Technologies. The Motley Fool has a disclosure policy.
The Stock Market Is Doing Something for Only the 3rd Time in 156 Years — and if Historical Precedent Is Accurate, the S&P 500 May Be Headed for Disaster was originally published by The Motley Fool