If the positive momentum holds up, 2024 will end up being another fantastic showing for the S&P 500 (^GSPC 1.09%). As of Dec. 17, the broad index had climbed 27% this year after rising 24% in 2023. Investors are very bullish as we look to 2025 and beyond.
However, with the widely followed benchmark trading in record territory right now, valuations could be stretched. Investors should therefore pay attention to a key metric that might be flashing a major warning. (In fact, nervous investors sent the Dow sinking 10 straight trading days in mid-December.)
But even after understanding this data point, it might still be a smart idea to invest your hard-earned capital. Here’s what you need to know.
Look at the CAPE ratio
One popular method of gauging the S&P’s valuation is the CAPE ratio (short for the cyclically adjusted price-to-earnings ratio). Using an average of inflation-adjusted earnings over the trailing-10-year period, this figure smooths out variability in profits to come to a more comprehensive number for the denominator. A higher CAPE ratio is a harbinger of poor returns to come, while a lower ratio means investors are in for strong returns.
The CAPE ratio currently sits at 35.2. In the past 145 years, it has been higher on only three other occasions (the Great Depression, the dot-com bubble, and at the end of the 2021 bull market). In the years that followed those two older peaks, investors lost money. On the other hand, the S&P 500 has actually risen since the most recent peak in November 2021.
Nonetheless, it’s reasonable for investors to worry that the market is due for a correction in the near term, based on the elevated CAPE ratio. So, it makes sense if there’s some hesitation to put money to work right now.
Image source: Getty Images.
This time, it’s different
Investors who don’t appreciate past trends, cycles, and human behavior seem to always believe that things are different this time around. But to be fair, things are really always different, as factors shift over time to reflect new market dynamics.
Consequently, what if the current CAPE ratio of 35.2 isn’t a major warning sign? A decade ago, this metric stood at 26.6, which at the time was still a historically expensive level. But in the 10 years that followed, the S&P 500 generated an annualized total return of 13.9%, a wonderful result.
I’m starting to believe that what was considered an expensive valuation in the past might today be viewed as a more reasonable valuation. That perspective is influenced by four important developments that have been too hard to ignore
The first one is the popularity of passive investing. In the U.S., there is more money in passive investment vehicles than there is in active ones. Secondly, the advent of zero-fee brokerage services has made investing in the stock market accessible to anyone.
While those two factors might seem obvious, investors should also consider the third: the rise of massive technology companies. Compared to the capital-intensive, manufacturing-focused corporations of previous generations, these new age enterprises are capital-light, benefit from network effects, generate sizable cash profits, and have growth potential. Surely, they warrant higher valuation multiples.
Lastly, ongoing currency debasement also can’t be overlooked. In the past decade, the M2 money supply, a measure of cash and money in checking, savings, and liquid money market accounts, has almost doubled. Greater liquidity pumped into the financial system should find its way into the stock market.
Taken together, the popularity of passive investing, democratization of brokerage access, rise of dominant tech firms, and currency debasement all result in more capital flooding into the equity markets. Consumers deal with inflation for the price of goods and services. Why can’t there also be inflation when looking at various asset classes?
Maybe valuations thought to be expensive historically are now considered reasonable or even cheap. It’s a good idea to be aware of where the CAPE ratio is, but for long-term investors who have decades until retirement, it’s not as important. It’s still a smart idea to invest today, as time in the market is really what matters. Adopting a dollar-cost averaging strategy is even better.
