A Particular Indicator of Stock Values has Occurred Infrequently Since the Launch of the S&P 500. Here's What Typically Follows.
In January, the S&P 500 firmly established its position in a bull market, aiming for a second consecutive year of double-digit growth. It's surged by 25% this year, following a 24% growth in 2023. The sector leading this charge is growth stocks, particularly those in the booming field of artificial intelligence (AI). Due to AI's potential to revolutionize both personal and professional lives, investors have been flocking to AI-related companies.
Many of these AI-focused stock market juggernauts have seen significant growth, propelling AI to the forefront. Companies like Nvidia (down 1.22% - NVDA) and Palantir Technologies, both AI chip designers and software companies, have surged by approximately 200% and 250% respectively. Tech giants Amazon and Meta Platforms, also heavy investors in AI, are also on track for double-digit gains.
This wave of growth has pushed one specific stock valuation metric to a level it's only reached three times since the S&P 500's debut as a 500-company index in the late 1950s. Let's delve into the details and contemplate what might happen next.
The S&P 500 Shiller CAPE ratio
The metric I'm discussing is the S&P 500 Shiller CAPE ratio. Similar to a conventional price-to-earnings ratio, it gives us a glimpse into a company's earnings in relation to its price. However, the Shiller CAPE ratio is different in that it's inflation-adjusted, considering a company's earnings over a 10-year period. Consequently, many consider it a more accurate representation of a stock's value.
At present, this metric has surpassed the level of 35 for the third time since the late 1950s, occurring during market rallies following the coronavirus market crash and in 2000 before the dot-com bubble burst.
This indicates that the market is generally quite expensive -- in fact, it's at one of its priciest points since the introduction of the S&P 500 we know today. History suggests that after peaks in the Shiller CAPE ratio, the S&P 500 has declined, implying that this could potentially transpire in our present scenario.
However, prior to entertaining the possibility of declines, it's essential to keep a few things in mind. Firstly, there's no way to predict when a decrease might occur. Excitement about ongoing growth in the AI market or optimism about the economy -- for instance, after a recent interest rate cut -- could perpetuate this positive trend. Selling your stocks out of fear of potential declines could potentially lead to missing out on this trend.
Some stocks perform well in adverse conditions
Secondly, a slump in the general stock market does not mean all your stocks will drop. Some of your investments may fare well or even prosper during a market downturn. A challenging market phase is unlikely to adversely affect all your investments, and your portfolio could perform better than you might have anticipated.
Furthermore, it's worth noting that just because the market as a whole appears to be pricey, this does not imply that every stock is overvalued. Even with the Shiller CAPE ratio reaching a high, some stocks continue to offer value. For example, tech titan Alphabet (down 0.53% - GOOG and 0.63% - GOOGL) currently trades at 22x forward earnings estimates, which seems reasonably priced considering its impressive earnings history and future prospects.
Lastly, while investing, it's vital to concentrate on long-term gains rather than short-term fluctuations. Stocks will move through bull markets and bear markets -- history demonstrates this. But if you buy top-notch companies at reasonable prices and hold onto them over the long term, you need not fear an impending market decline. Bull markets often last far longer than bear markets, providing quality stocks ample time to succeed if you hold them for the long run.
In light of the surging growth in the AI sector, many investors are turning to investing in AI-related companies, such as Nvidia and Palantir Technologies, whose stocks have seen significant increases of around 200% and 250% respectively. Despite the high Shiller CAPE ratio, indicating a generally expensive market, some stocks, like Alphabet, still offer reasonable value and prospects for long-term gain.
The S&P 500's Shiller CAPE ratio, similar to a price-to-earnings ratio, gives a glimpse into a company's earnings in relation to its price and is inflation-adjusted over a 10-year period. At present, this metric has surpassed the level of 35 for the third time since the late 1950s, indicating a potentially pricey market.
