The S&P 500 is currently valued at a forward price-to-earnings ratio of 22.3, surpassing its five-year average of 19.7 and the 10-year average of 18.1. This marks the highest valuation seen since April 2021. Historically, the S&P 500 has only exceeded 22 times forward earnings on two occasions since 1985, both leading to significant declines in the index afterwards.
The initial instance occurred during the dot-com bubble between 1998 and 2000, where the S&P 500 plummeted by 49% after peaking in March 2000. The second instance was during the Covid-19 crisis.
Investors misjudged the ramifications of supply chain disruptions and stimulus measures, resulting in inflated stock prices. The S&P 500 reached its apex in January 2022 before experiencing a 25% drop.
Surging stock valuations call for prudence
Presently, the PE ratio based on the previous 12 months’ earnings stands at 28.7. This significantly exceeds the five-year average of 24.1 and the 10-year average of 21.9. Historical data shows that the S&P 500 has never recorded a positive 10-year return when initiating with a PE ratio above 25. Goldman Sachs anticipates a mere 3% annual return for the S&P 500 over the next ten years.
This projection is considerably lower than the long-term average return of 11% annually. Nonetheless, Goldman has highlighted that a limited number of firms exhibit excessively high valuations, while the remaining 490 stocks in the index are more reasonably priced.
Goldman forecasts that these reasonably valued stocks may outperform the S&P 500 by an average of 5 percentage points each year in the coming decade. With the S&P 500 experiencing a notably elevated forward PE ratio, investors must exercise caution regarding valuations when investing in stocks at this time.
It might also be prudent to maintain a greater cash reserve, which would facilitate seizing opportunities during any market downturns.
