A strong economy and excitement surrounding artificial intelligence (AI) have supercharged the stock market. The benchmark S&P 500 (^GSPC -0.00%) it has returned nearly 27% so far in 2024, hitting 57 record highs in the process. The index most recently peaked at 6,090 on December 6, and is currently trading just below that level.
Most investors are wondering the same thing: Is it smart to buy stocks now? The S&P 500 has done historically well after reaching a record high, and the average bull market is lasting much longer than the one currently underway. But there’s also an alarm bell that can’t be ignored: The S&P 500 is trading at an almost unprecedented valuation.
Here’s what investors need to know.
The S&P 500 has historically done well after hitting an all-time high
Isaac Newton’s first law of motion states that objects in motion will continue to move unless something stops them. The same principle tends to apply to the stock market. The S&P 500 hit record highs like a freight train this year, and upward momentum generally persists until something goes wrong.
That suggests investors have little to fear from record highs. In truth, JP Morgan analysts recently compared the average forward return from record highs in the S&P 500 versus the average forward return from non-record highs. The S&P 500 is performing the same or better from record highs than from all other times.
|
Period of time |
Average return on investments made at record highs (1970-2024*) |
Average Return on Investments Made in Other Times (1970-1924*) |
|---|---|---|
|
Six months |
4% |
4% |
|
12 months |
9% |
9% |
|
24 months |
19% |
18% |
Data source: JPMorgan Chase. The calculations run until September 4, 2024.
As shown above, since 1970, the S&P 500 has returned an average of 9% over the 12 months following a day when the index hit a record high. The S&P 500 also returned an average of 9% over the 12 months following any other day. This suggests that 2025 will probably be a positive year.
Bull markets are historically longer and higher than the current one
The average bull market since 1949 lasted five and a half years, during which the S&P 500 (and its predecessor index) returned an average of 192%, according to Goldman Sachs. For comparison, the current bull market started about two years ago, in October 2022, and the S&P 500 has returned 70%.
The S&P 500 was trading at 3,577 when the current bull market began. Adding 192% suggests that the index could reach 10,445 before the bull market ends (if average). Getting to that level would require returns of 17% annually over the next three and a half years. That suggests double-digit gains are likely in 2025.
Image source: Getty Images.
The S&P 500 is trading at an almost unprecedented valuation
Robert Shiller is a Nobel Prize-winning economist who developed a valuation metric known as the cyclically adjusted price-to-earnings (CAPE) ratio. The metric is also known as the Shiller PE, and is commonly applied to the S&P 500 to determine whether the stock is overvalued or undervalued.
Traditional price-to-earnings ratios are calculated as the price divided by the earnings of the past 12 months. But the CAPE ratio is calculated as the price divided by the average rate of inflation of the last 10 years. In general, high CAPE ratios correlate with worse forward returns, while low CAPE ratios correlate with better forward returns.
The S&P 500 currently has a CAPE ratio above 38, one of the highest readings on record. Since the index was created in 1957, its monthly CAPE reading has topped 35 only 52 times. To put it in context, 815 full months have passed since the beginning of 1957, and the CAPE ratio exceeded 35 in only 6% of those months.
Here is the bad news: US & P 500 has decreased by an average of 1.3% in the year following a monthly CAPE reading above 35. This does not necessarily mean that the index will decrease the following year. Under similar circumstances, the S&P 500 generated a one-year return ranging from 38% upside to 28% downside. But the average was 1.3% downside, and investors can not afford to ignore this.
Is it smart for investors to buy stocks now?
The S&P 500 has generally performed well since record highs, and history suggests that the current bull market may continue for several more years. But investors cannot afford to be careless. Valuations are widening in the stock market, which could make 2025 a challenging year.
Anecdotally, I’ve heard a surprising number of experts—both Wall Street pros and YouTube hobbyists—suggest that valuations should be ignored right now. That advice is very dangerous. Ratings are like seat belts. They don’t seem to matter until they do, and ignoring them even temporarily can have very bad consequences.
Personally, I think now is a good time to accumulate money in wallets. This does not mean that investors should pass on reasonable buying opportunities. But it does mean they should examine these opportunities closely. The S&P 500 is historically expensive, which suggests a drawdown (possibly a sharp one) once its momentum falters.