Buying the stock market when valuations are this high has seldom worked
The year just ended saw more strong gains for the stock market, but with valuations at levels only seen during the Covid-19 pandemic and the dot-com bubble, trouble could be on the horizon. Last year, technology companies led the S & P 500 to rally more than 16%, extending the run that began in late 2022, when the index advanced more than 24% in 2023 and 23% in 2024. But for anyone looking for bargains, look again. The cyclically adjusted price-to-earnings, or CAPE, ratio – a measure of the stock market’s valuation developed by Yale University economics professor Robert Shiller – also finished last year at 40. Coupled with the S & P 500’s forward price-to-earnings ratio of around more than 22, according to FactSet, the two measures may well mean that the long-term future isn’t so bright, according to Mebane Faber of Cambria Investment Management. “While this isn’t a red flashing light that stocks have to crash, it is a yellow warning that the broad market is expensive,” the firm’s chief investment officer told CNBC, adding that when the market’s valuation ends the year above 40, future 10-year returns are historically “near zero, after inflation.” “Never once in our research has a 40 CAPE ratio resulted in above average returns over the next decade,” he said. “That’s the bad news.” The good news, however, is that outside the U.S., most of the markets in the rest of the world are “cheap to very cheap,” Faber noted. “Even within the U.S., both value stocks and small- and mid caps offer much better bargains than expensive mega caps,” he said. In fact, the CAPE reading of 40 is mostly from “about a dozen to 20 names,” said Keith Buchanan of Globalt Investments. There’s “better bang for the buck” beyond the top-weighted stocks. “Diversification is the key to outperformance going forward in 2026,” the senior portfolio manager said. “We want to own the names that are below the median valuation,” especially small-caps, to take one example. Others say current valuations aren’t much of a concern. Venu Krishna, head of U.S. equity strategy at Barclays, said in a report on Wednesday that valuations “look reasonable” to start the year. “While 22x [next 12-month month] EPS is not cheap by any stretch, in our view, current levels have not historically impeded returns, provided EPS growth remains positive,” he said. “While we do think that current Street estimates for NTM and FY26 are overly optimistic, we still expect the S & P 500 to print double-digit EPS growth this year.”
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