The stock market appears to be on its way to another strong year, with the S&P 500 (SNPINDEX: ^GSPC) once again up by double-digit percentages. However, warning signs of a potential market pullback have been growing, including the S&P 500 hitting rarely seen valuation levels and the Federal Reserve starting to raise interest rates.
Let's look at what history says about situations like this and whether there is reason to believe that history will repeat itself or if this time will be different.
Missed AI's "Act 1"? Act 2 Could Be 15x Bigger. Most investors think they missed the AI boat because they didn't buy Nvidia in 2005. But according to our analysts, we're only at the end of "Act 1"—the R&D phase. "Act 2" is the global rollout. Continue »
Stocks are at historically high valuations
There are a variety of ways to value the stock market, but one of the more popular is the S&P 500 cyclically adjusted price-to-earnings (CAPE) ratio. Developed by famed economist Robert Shiller, this valuation metric was devised to help smooth out cyclical boom-bust profit cycles and show a better picture of the market's earnings power as opposed to conventional P/E ratios, which can be greatly influenced by economic cycles. It does this by taking the S&P 500's current price and dividing it by its average annual earnings adjusted for inflation over the past decade.
The metric was designed to be an indicator of potential future market returns over the following decade, but it has often been used to help predict market crashes. The S&P 500 has historically traded at an average CAPE ratio in the mid-17s, but it's often climbed to high levels preceding market crashes, including around 27 before the Great Recession and near 30 before the Great Crash of 1929.
The CAPE ratio climbed above 40 earlier this year and has remained above that mark. The only other time the market has hit this level, going back into the 1800s, was during the dot-com bubble before the market crashed.
Another popular valuation for the S&P 500, which has surged to new all-time highs, is the so-called Buffett indicator. The valuation metric is a favorite of legendary investor Warren Buffett. It measures the value of the entire stock market, as reflected by the Wilshire 5000 Index divided by the U.S. gross domestic product (GDP). A reading between 75% and 90% is considered a reasonable valuation, while above 120% is viewed as overvalued. The metric has recently reached an all-time high, soaring to above 235%. The ratio reached high levels before the dot-com crash and the global financial crisis, but it's generally been climbing to new highs since late 2017.