Beware the return of the S&P 500 bubble

The S&P 500 has been the index of choice in the wake of the 2008-9 global financial crisis.

With dividends included, the US large-cap index has returned almost 1,000% since early 2009, which in annualised terms is an exceptional 17%.

This has been fantastic for investors who made their fortune riding this bull, but bulls can also be destructive. If you’re riding high on the back of one, make sure you’re wearing safety gear.

Bulls are okay, bubbles are dangerous

There is nothing wrong with bull markets. They draw in new investors, they make it easier and cheaper for companies to raise productive capital and they add spice to the world of investing.

But you can have too much of a good thing, and when a bull market goes on for too long, it can create a dangerous bubble.

Bubbles occur when valuations rise too high, typically after long periods of economic growth. Investors gradually become too optimistic and confident that the economic summer will last forever, but it never does. Instead, summer turns into winter and booms turn into busts.

In the 20th century, there were two US large-cap bubbles and they both burst:

• When the 1920s bubble burst, it was followed by an 85% decline and the S&P 500 took 25 years to recover
• When the 1990s bubble burst, it was followed by a 45% decline and the S&P 500 took 13 years to recover

Today, there is little doubt that the S&P 500 is in another bubble.

The S&P 500 is in another bubble

A bubble occurs when prices are too high compared to business fundamentals like earnings or assets.

The cyclically adjusted PE ratio (CAPE or Shiller PE) is a popular valuation ratio that has proven superior to the standard PE at identifying bubbles. Here’s a chart showing the S&P 500’s CAPE over the last 143 years (using data provided by Professor Shiller).

CAPE moves up and down as the US economy and stock market swing between booms and busts, but for most of the last 143 years, CAPE stayed between 10 and 20. In recent decades, CAPE mostly stayed between 20 and 40, leaving the 100-year average at 19.

To identify a stock market bubble, we can compare CAPE to its long-term average. More precisely, I define a bubble as a period where CAPE is more than 100% above its 100-year average.

For some additional context, here’s a chart showing the S&P 500’s last 40 years, projected against a rainbow that reflects the full spectrum of CAPE-based valuation levels from depression (50% below average) to bubble (100% above average).

Until recently, the S&P 500 had only reached bubble levels three times in the last 100 years:

• 1929, when CAPE reached 31.3, 125% above its average at the time
• 1997-2001, when CAPE reached 44.2, 190% above its average at the time
• 2021, when CAPE reached 41.5, 111% above its average at the time

Today, the S&P 500’s CAPE is 38.1, which is 102% above average. That means the S&P 500 is now in its fourth bubble of the last 100 years, which has already been labelled the AI bubble.

Some will argue that this isn't a bubble because the Internet and AI have fundamentally changed the game. They will argue that the US tech giants will continue their rapid growth for decades to come, thereby justifying the US market’s exceptionally high CAPE ratio.

I have my doubts. There were equally huge technological advances between 1881 and 1991, such as widely available electricity, internal combustion engines, aeroplanes and computers to name just a few. Despite those world-changing advances, CAPE stayed almost exclusively within the 10 to 20 range throughout those 110 years, coming nowhere near today's CAPE of almost 40.

Instead of assuming this time is different, a more conservative assumption is that this time isn’t different and that the S&P 500’s high CAPE ratio is strong evidence that the index is in a bubble.

This is a problem for millions of investors because bubbles are almost always followed by bad returns over the next decade or more.

Bubbles are hazardous to investors' wealth

Bubbles are bad for future returns for two reasons.

First, high share prices lead to low dividend yields, so when the stock market is in a bubble, investors get a smaller return from dividends.

Second, CAPE has always reverted to its long-term average, so when CAPE is above average we should expect it to fall, and when CAPE is a long way above average, we should expect it to fall a long way. Unfortunately, that fall is usually driven by falling share prices rather than rising earnings.

Here’s a chart showing the relationship between the S&P 500’s CAPE and the index’s subsequent ten-year total return.

Each dot is the data from one month.

The horizontal x-axis shows the difference between CAPE and its 100-year average, so the dots to the right of 100% represent months when the S&P 500 was in a bubble. Conversely, I define a depression as a period where CAPE was more than 50% below average, so the dots to the left of -50% are months where the S&P 500 was at depression levels.

The vertical y-axis shows the S&P 500’s annualised total return over the ten years after the CAPE valuation was taken.

There is a clear inverse relationship between valuation and subsequent returns. When valuations are very high (the right side of the chart), subsequent returns are very low, and when valuations are very low (the left side of the chart), subsequent returns are very high.

More specifically, when the S&P 500 was in a bubble, subsequent ten-year annualised total returns were never above 10%; they mostly fell into the 0-5% range and were often negative.

With the S&P 500 back in bubble territory, investors should expect the S&P 500 to produce historically average returns from these levels, which means annualised total returns of between -3% and 8% over the next ten years.

If I had to pick a single figure (which is a bad idea as future returns are highly uncertain), I would pick the average annualised total return from these levels, which is 3%.

Coincidentally, Goldman Sachs also expects a 3% annualised total return from the S&P 500 over the next ten years.

3% is far below the S&P 500’s long-term average return of around 10%, so investors piling in today should expect weak returns, which isn’t good for them. But it’s worse than that.

Bubbles aren’t dangerous because they typically lead to weak ten-year returns; they’re dangerous because they lead to market crashes. Market crashes cause inexperienced investors to sell out at the bottom, often crystalising huge losses that take years or even decades to recover from.

As a quick reminder:

• After the 1929 bubble, the market fell 85% and took 25 years to recover
• After the 1999 bubble, the market fell 45% and took 13 years to recover

The 2021 meme-stock bubble was followed by a 20% decline, but it didn’t fully burst. Instead, it was reinflated by optimism around AI, so many investors now think this bubble will never burst. History, on the other hand, strongly suggests that it will.

When the bubble bursts, if the S&P 500’s CAPE returns to the historically normal level of 19, the S&P 500 would fall by 51% to 2,990. From personal experience, I know that many investors will panic-sell when their investments are down 50% or more, and some of them will never invest in shares again.

That is one of the worst possible outcomes, so what can investors do to avoid that fate?

Reducing the risk of a bursting S&P 500 bubble

The standard way to reduce country-specific risk is to buy a global index tracker. That approach has merit, but the US now makes up 65% of global equity indices. Rather than providing investors with broad geographical exposure, global trackers are now US trackers with a small allocation to international stocks.

Fortunately, there are better strategies investors can use to reduce their exposure to the US bubble. Here are just a few:

1. Have at least 50% of your investments in bonds, commodities and other non-equity asset classes.
2. Allocate equity investments across several regional trackers. For example, invest one-third in each of a US tracker, a European tracker and an Asia Pacific tracker and rebalance annually.
3. Invest in the US, but avoid the bubble by investing in individual stocks with high dividend yields and attractive valuations.
4. Invest in cheaper markets like the UK, where expected ten-year returns are higher.

When a long bull market produces a bubble, it can be hard for investors to accept that their recent high returns won’t continue forever. History tells us that the S&P 500 is far more likely to crash than remain in an everlasting bubble, so investors should be prepared.