The S&P 500 Is Approaching a Valuation Not Seen in 26 Years, and History Suggests a Crash Could Follow

The S&P 500 (SNPINDEX: ^GSPC) is made up of 500 companies from 11 different sectors of the U.S. economy. Its high degree of diversification is why it's one of the most widely followed stock market indexes in the world.

The S&P 500 delivered blistering returns over the last few years, fueled by the artificial intelligence (AI) boom, which created trillions of dollars in value for some of its largest members. It's now trading at the second-highest valuation in its history, based on the Shiller Cyclically Adjusted Price-to-Earnings (CAPE) ratio. The CAPE ratio is calculated based on the average earnings of the companies in the index over the last 10 years, adjusted for inflation.

The S&P 500 had a CAPE ratio of 40.5 at the close of trading on Wednesday, not far from its all-time high of 44.2, which marked the peak of the dot-com internet bubble in the year 2000. The index plummeted by 49% when the dot-com bubble eventually burst, so now might be a good time for investors to tread with caution, especially because the risks to the current bull market are mounting.

Here's what investors need to know, and what they should do going forward.

Image source: Getty Images.

The stock market faces a number of headwinds

There is no such thing as a perfect environment for investing. War, elections, changes in interest rates, and technological shifts are just a few things that can spark volatility, and at least one of them is a factor practically all the time. But investors are contending with several of those headwinds right now, which could trigger a sharp sell-off in the S&P 500.

First, the ongoing geopolitical tensions between the U.S. and Iran have sent oil prices soaring. A single barrel of West Texas Intermediate crude is trading at over $100 as I write this (Sept. 17), significantly higher than its 2026 opening price of $57. Oil is a critical input cost for any product that travels by truck, boat, or plane, so people are not only facing higher prices at the pump, but also at the grocery store and at their favorite retailers.

This is stoking inflation. The U.S. Consumer Price Index (CPI) rose at an annualized rate of 3.4% in August, much higher than the Federal Reserve's target of 2%. The energy component alone rocketed higher by more than 16%, laying bare the effects of rising oil prices. To bring inflation under control, the Fed raised interest rates by 25 basis points at its September meeting on Wednesday, and it signaled one more hike might be on the way before the end of 2026.

The Fed's last hiking cycle started in March 2022 and ended in August 2023. During that 18-month window, the S&P 500 plunged by more than 20%, which constituted a technical bear market. Rising interest rates negatively affect everything from consumer spending to corporate earnings, so they almost always weigh on the stock market.

It gets worse. Dario Amodei, the founder of Anthropic, recently published a blog post calling for a slowdown in the pace of AI development to help manage the growing risks to humanity. His peers, Sam Altman from OpenAI and Elon Musk from xAI, shared social media posts agreeing with his sentiment. If three of the world's top AI labs really do pump the brakes, it might be bad news for semiconductor suppliers like Nvidia and Micron Technology, which have contributed a significant amount of upside to the S&P 500 over the last few years.

If all that isn't enough, Americans will head to the polls on Nov. 3 for the midterm congressional elections, creating even more uncertainty for the stock market.

Here's what investors should do if the S&P 500 crashes

Volatility is a normal part of the investing journey. According to Capital Group, the S&P 500 typically suffers a decline of 10% or more every 18 months or so. Bear market declines of 20% or more are rarer, but they tend to come around every six years -- and we are already four years removed from the last one.

But remember this: The S&P 500 has delivered a compound annual return of 10.7% since its inception in 1957, even after accounting for every sell-off, correction, and bear market along the way. That means staying invested during volatile periods is the secret to success. In fact, buying stocks when everyone else is panic-selling has actually been a winning strategy over the last 60 years.

Based on the numerous headwinds I've highlighted, combined with the high valuation of the S&P 500, a near-term stock market sell-off almost feels inevitable. Therefore, investors might soon have a golden opportunity to put some money to work.

Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Micron Technology and Nvidia. The Motley Fool has a disclosure policy.