U.S. stock market reaches record highs

The S&P 500 Index has returned 27% year-to-date in one of its strongest performances of the 21st century. However, a Conference Board survey revealed that 56.4% of U.S. consumers expect the stock market to rise over the next year, the highest reading on record. Morgan Stanley views this as a contrarian indicator highlighting irrational optimism amid stretched valuations. The S&P 500 has a forward price-to-earnings (PE) ratio of 22.3, a substantial premium to the five-year average of 19.7 and the 10-year average of 18.1. Historically, the index only saw forward PE ratios that high during the dot-com bubble and the COVID-19 pandemic. Both times resulted in significant declines. The S&P 500 now trades at 28.7 times earnings, a substantial premium over the five-year average of 24.1 and the 10-year average of 21.9. According to LPL Research, the S&P 500 has never generated a positive 10-year return when the initial PE multiple exceeded 25.

High valuations necessitate investor caution

Goldman Sachs updated its 10-year outlook for the S&P 500 in October. Analysts expect the benchmark index to generate a total return of 3% annually over the next decade, significantly below the long-term average of 11%. However, the report noted that the high valuations are primarily due to a handful of companies. The top 10 stocks have a premium valuation reminiscent of the dot-com boom in 2000, implying that the remaining 490 stocks are more attractively priced and offer more upside potential. The S&P 500 is currently trading at a historically high forward PE multiple, necessitating caution for investors regarding valuations. Accumulating extra cash now could enable investors to capitalize on future market opportunities.