The S&P 500 is trading at a forward price-to-earnings ratio of 22.3. This is higher than the five-year average of 19.7 and the 10-year average of 18.1. The stock market has not been this expensive since April 2021. The S&P 500 has traded above 22 times forward earnings only twice since 1985. Both times, the index fell sharply afterward.
The first time was during the dot-com bubble from 1998 to 2000. The S&P 500 declined 49% after peaking in March 2000. The second time was during the Covid-19 pandemic.
Investors underestimated the impact of supply chain issues and stimulus spending. This drove many stocks to high valuations. The S&P 500 peaked in January 2022 and then fell 25%.
Peaking stock valuations prompt caution
The current PE ratio, based on the last 12 months of earnings, is 28.7. This is much higher than the five-year average of 24.1 and the 10-year average of 21.9. Since 1990, the S&P 500 has never had a positive 10-year return when the starting PE ratio was over 25. Goldman Sachs expects the S&P 500 to return only 3% per year over the next decade.
This is far below the long-term average of 11% per year. However, Goldman noted that a small number of companies have very high valuations. The other 490 stocks in the index are priced more reasonably.
Goldman believes these stocks could beat the S&P 500 by 5 percentage points per year over the next decade. The S&P 500 is trading at a very high forward PE ratio. Investors should be careful about valuations when buying stocks right now.
It may also be a good time to hold more cash. This would make it easier to take advantage of any market declines.
