What History Reveals When the S&P 500 Sends Its Rarest Warning Signal

Many investors are worried that the U.S. stock market is getting too expensive. A widely watched metric for the S&P 500 index (SNPINDEX: ^GSPC) valuation is the Shiller CAPE Ratio. By calculating cyclically adjusted price-to-earnings ("CAPE"), this metric is meant to be a more consistent way to compare how expensive or undervalued the S&P 500 might be over time, across all kinds of economic conditions.

As of Sept. 6, the CAPE Ratio is 41.18. That's its highest level since 1999-2000, right before the dot-com crash. The CAPE ratio doesn't exceed 30 very often. But when it does, a stock market crash often follows. The first time the CAPE Ratio exceeded 30 was in 1929, right before the Great Depression.

S&P 500 Shiller CAPE Ratio data by YCharts

Seeing the S&P 500 index at such high valuations, as indicated by the CAPE Ratio, can be seen as a rare warning signal for investors. But does this mean you should sell your stocks, change your portfolio allocations, or stop investing altogether?

No. The CAPE Ratio is well-regarded and worth watching, but like any other stock market metric, it's not 100% guaranteed to predict the future. And even if a stock market crash is coming soon, now could still be a good time to buy if you're a long-term investor.

Let's look at what long-term investors should do if they're worried about high valuations of the S&P 500 -- and why the answer might be "nothing."

Image source: Getty Images.

Don't try to time the market

It's understandable that savvy investors would be concerned about metrics like the CAPE Ratio. But try not to overreact. High valuations of the S&P 500 don't automatically mean that the stock market will crash anytime soon. Most of the time, buy-and-hold investors do better than investors who try to "time the market" by saying to themselves that "stocks are too expensive" or "now is a bad time to buy."

Fidelity research has found that even when stock prices are at all-time highs, this is often a better time to buy stocks. Since 1950, average total returns for the S&P 500 were slightly higher in the 12 months following an all-time high compared to other 12-month periods. High stock prices are often a sign that the economy is growing strongly and that investors are optimistic about the future -- and will keep buying stocks.

Remember, the Vanguard S&P 500 ETF (NYSEMKT: VOO) has delivered average annual returns of about 15% since the fund's inception 16 years ago. That includes the 2022 bear market and crises like the COVID-19 pandemic.

Over an even longer time frame, the S&P 500 has delivered annualized returns of 10% per year since 1928. That includes all the big world-changing crises and crashes along the way in the past 98 years. Bad news happens, but panic is the enemy of wealth-building. Long-term investors who keep calm and hold onto their stocks are likely to keep winning.

Why you should buy stocks, even with high valuations

The risk of missing out on future stock market gains is often bigger than the benefits of avoiding a stock market downturn. The CAPE Ratio doesn't have to be something to fear. With a long-term investment time horizon of five to 10 years or more, most investors are likely to be better off by just continuing to buy and hold a diversified portfolio of stocks.

Low-cost index funds like the Vanguard S&P 500 ETF can be an easy way to do this. Leave your money alone to go through the inevitable short-term ups and downs, and you're likely to see strong returns over time.

Ben Gran has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.