The Stock Market Is Flashing a Rare Warning Signal. Here's How History Says Investors Should Prepare.

Key Points

• One pressing topic investors are thinking about these days is the S&P 500 index’s all-time high valuation.
• When the CAPE ratio was above 40 in the past, the market saw negative annualized returns over the next decade.
• Selling off their portfolios and waiting for a cheaper entry point is the worst thing that investors can do.
• 10 stocks we like better than S&P 500 Index ›

The S&P 500 index (SNPINDEX: ^GSPC) has been on a marvelous run. In the past decade, it has generated a total return of 321% (as of Sept. 18). Had you invested $10,000 in September 2016 in an exchange-traded fund (ETF) tracking the benchmark, you'd have $42,100 today. From a historical perspective, this is exceptional.

If you had a strong allocation to equities during this time, then you're not complaining at all. But it's worth understanding the present situation clearly. This way, you can set the right expectations about what the future might bring.

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Right now, the stock market is flashing a rare warning signal. Here's how history says investors should prepare.

Valuation is a leading concern

The investment community is thinking about many things these days. The artificial intelligence (AI) infrastructure boom, primarily related to how long the party can last, is a focal point. Moreover, the Federal Reserve's interest rate policy is another important topic that's always grabbing headlines.

However, valuation is also at the center of attention. And there's a key data point that investors might view as a clear warning sign.

The cyclically adjusted price-to-earnings (CAPE) ratio is currently 41. It's up 55% in 10 years. And it has never been this expensive in history outside of the dot-com bubble era at the turn of the century. In November 1999, it peaked at a level of more than 44.

According to the data, anytime the CAPE ratio has been above 40, the S&P 500 index has registered a negative annualized total return over the subsequent decade. This mainly coincides with the 2000s decade following the end of the internet tech-fueled mania.

Your first thought might be to dump your portfolio holdings and move to cash and bonds in an effort to de-risk and boost safety. However, this would be a poor decision

Stay the course

The topic of equity valuations isn't new. In fact, it seems to always be a paramount issue that investors have grappled with.

It's not that difficult to find numerous headlines from the early and mid-2010s pointing out that valuations were elevated by historical standards. And often, the outlook was that returns going forward would be subpar, and investors should lower their stock weighting in their portfolios.

Everyone knows how this played out. The S&P 500 index produced a total return that grew investor capital by more than fourfold in the last 10 years. Assuming you listened to the warning calls, you would've harmed your personal finances and missed out on an incredible run.

Investors should learn something from history. Despite the constant chatter about valuations, which I believe won't quiet down, the best thing to do is always stay the course. Don't try to time the market even though it's very tempting to believe you can move in and out of the market to avoid the down days and capture the winning days. This is a recipe for disaster.

The investors who actually build wealth over time have developed the mental capacity to handle the ups and downs. Furthermore, just because valuations are elevated doesn't mean performance will be terrible in the future. The stock market is structurally different in 2026 than at any point in the past.

Dominant technology companies have earned their massive valuations, as they continue to grow earnings at an impressive rate. And the AI build-out has introduced another growth lever. Passive investment funds now control more capital than active ones. As this trend continues, it brings greater demand to buy equities irrespective of valuations.

It's always insightful to look at history to gain a clearer perspective on markets and the economy. After doing this exercise, the conclusion is to continue investing early and often with a long-term focus.

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Neil Patel has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.