To The Moon

In just over 17.5 months, the $DJIA(.DJI)$ has surged 17%, the $S&P 500(.SPX)$ has jumped 42%, and the $NASDAQ(.IXIC)$ has skyrocketed 69%. Even more remarkable, all three major US stock indexes have hit new closing highs, confirming a bullish market.

Moreover, most of the S&P 500 constituents have exceeded earnings expectations, and the US economy remains robust. But, as the saying goes, "All good things must come to an end." While AI hype has provided a boost, the US stock market can't go up forever, it'll eventually come down.

But qualitative judgments are not that helpful. Investors need quantitative indicators to help us gauge the broader direction of the US stock market, like the valuation-driven Shiller P/E ratio, often referred to as the Cyclically Adjusted Price-to-Earnings (CAPE) ratio.

Unlike traditional P/E ratios that use earnings from the past 12 months, the Shiller P/E ratio for the S&P 500 is based on earnings adjusted for the average inflation rate over the past 10 years, eliminating the impact of one-time events like COVID-19 that can skew valuation analysis.

Breached 30 six times in 153 years

As of June 13th's closing bell, the Shiller P/E ratio for the S&P 500 stands at 35.38, a high during bull market rallies since 1871 and more than double the 153-year average of 17.13. But here's the scary part: whenever this ratio breached 30 during bull market rallies, look what happened to the US stock market afterwards.

From August to September 1929: Just before the Great Depression, the Shiller P/E ratio hit 30 for the first time, and the Dow plunged 89% thereafter.

From June 1997 to August 2001: During the dot-com bubble, the Shiller P/E ratio for the S&P 500 hit an all-time high of over 44, and the index fell 49%, while the Nasdaq lost 75%.

From September 2017 to November 2018: After a prolonged bull run, the Shiller P/E ratio breached 30, and the index fell 20% in the fourth quarter.

From December 2019 to February 2020: Before the COVID-19 crash, the Shiller P/E ratio surpassed 30, and the S&P 500 lost 34% in just 33 days during the 2020 pandemic crash.

From August 2020 to May 2022: The Shiller P/E ratio hit 40 for the second time in recorded history in early January 2022. During the 2022 bear market, the S&P 500 fell 28%, and the Nasdaq fell even more.

From November 2023 to the present: As of June 13th, 2024's closing bell, the Shiller P/E ratio is above 35.

In 153 years, the Shiller P/E ratio has breached 30 six times, and in the previous five occurrences, the three major US stock indexes fell by more than 20%, with the highest drop being 89%. Following this pattern, the US stock market is likely to see a significant decline, perhaps even a short-lived "crash."

However, the Shiller P/E ratio isn't a timing tool. For example, the market remained at extremely high levels for over four years before the dot-com bubble burst. This means the current high valuations in the US stock market could persist for weeks, months, or even years.