Warren Buffett Warns Investors as the Stock Market Sounds an Alarm. History Says This Will Happen Next.

Through decades of disciplined investing, Warren Buffett turned Berkshire Hathaway from a struggling textile manufacturer into one of the largest companies in the world. Under his leadership, Berkshire Class A shares returned 19.7% annually over six decades, while the S&P 500 (SNPINDEX: ^GSPC) gained 10.5% annually.

Buffett, now 95, stepped down as Berkshire's CEO last year, but he recently shared a grim warning with investors during a CNBC interview. "We've never had people in a more gambling mood than now." Buffett also said traders were treating the stock market like a casino.

Of course, Buffett has regularly warned about the dangers of gambling in the stock market, so investors may be inclined to brush aside his latest words of caution. Unfortunately, there is a very good reason to take him seriously. The S&P 500 is incredibly expensive by historical standards. So expensive, in fact, that the index has never delivered a positive three-year return from its current valuation.

Here's what investors should know.

Image source: Getty Images.

The stock market sounds an alarm

In 1988, Nobel laureate economist Robert Shiller and his colleague John Campbell introduced the cyclically adjusted price-to-earnings (CAPE) ratio, a metric designed to determine whether entire stock market indexes were overvalued. Unlike traditional P/E ratios, which are based on earnings from the last four quarters, the CAPE ratio is based on inflation-adjusted earnings from the last decade.

The S&P 500 recorded a CAPE ratio of 39.7 in June. Excluding the last few months, that is the highest reading since the dot-com crash in September 2000. In fact, there have only been 29 incidents when the S&P 500's monthly CAPE ratio topped 39 since the index was created in 1957, meaning the stock market has been this expensive less than 4% of the time.

In hindsight, CAPE ratios higher than 39 have usually been a warning signal for investors. The chart below lists the S&P 500's best, worst, and average returns over different periods after CAPE readings above 39.

Data source: Robert Shiller. The chart above shows the S&P 500's average return during the one-, two-, and three-year periods following a monthly CAPE reading above 39.

As shown above, following a monthly CAPE reading above 39, the S&P has declined by an average of 4% over the next year, 20% over the next two years, and 30% over the next three years. In other words, history says the S&P 500 could fall sharply in the coming years, and the index could still be down substantially by July 2029.

The chart above includes another interesting data point. The S&P 500 has never delivered a positive three-year return after a monthly CAPE ratio above 39. Even in the best-case scenario, the index fell 10% under those circumstances. In other words, history says the S&P 500 is likely to lose value between today and July 2029.

Of course, past performance is never a guarantee of future returns. The CAPE ratio only looks backward, so it does not account for the possibility that earnings will grow faster in the future as artificial intelligence unlocks productivity across industries. Investors may be comfortable paying higher valuation multiples so long as the AI narrative remains intact.

Warren Buffett's advice for investors

In the early 2000s, low interest rates and lax lending standards created a housing bubble that, after bursting, dragged the economy into a devastating recession. By October 2008, the S&P 500 was down more than 40%, and Wall Street was bracing for further losses as the banking system buckled under the weight of the financial crisis.

That same month, Warren Buffett published an editorial piece in The New York Times, in which he passed along this now-famous advice: "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful."

At the time, fear had gripped even the most seasoned investors, so Buffett urged readers to be greedy. But the environment is different today. Many investors are too exuberant despite rich valuations. A healthy dose of fear is warranted in the current market environment.

That does not mean investors should avoid the stock market entirely. Instead, they should follow this advice from Buffett: "Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten, and twenty years from now."

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.