The Stock Market Sounds an Alarm After Warren Buffett Issues a Warning. History Says This Will Happen Next.

Key Points

• In May, Warren Buffett warned that many investors were treating the stock market like a casino.
• The S&P 500’s CAPE ratio was 41.1 in August, the highest valuation since the dot-com crash in September 2000.
• The S&P 500 will decline 30% over the next three years if its performance matches the historical average.
• 10 stocks we like better than S&P 500 Index ›

The U.S. stock market has delivered strong returns in 2026 despite economic uncertainty stemming from persistent inflation and elevated energy prices tied to the Iran conflict. The S&P 500 (SNPINDEX:^GSPC) has advanced 12% year to date.

The driving force behind those double-digit returns has been strong financial results. S&P 500 earnings are forecast to increase 32% this year, the fastest annual growth outside of a post-recession recovery in more than three decades.

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However, the S&P 500 just flashed a warning last seen during the dot-com crash, and it hints at substantial downside over the next two or three years.

Image source: Getty Images.

Warren Buffett warned investors about casino-like behavior in the stock market

Warren Buffett sat down for an interview with CNBC in May. He discussed everything from nuclear weapons and geopolitical risk to artificial intelligence and the macroeconomic environment. But a few of his comments stood out.

While discussing the market's increasingly speculative behavior, Buffett said. "We've never had people in a more gambling mood than now." He also warned that some investors were treating the stock market like a casino, making irresponsible bets that have left many valuations looking "very silly."

Buffett has made similar comments before. For instance, in his 2024 shareholder letter, he wrote, "Markets now exhibit far more casino-like behavior than they did when I was young." So, investors may be tempted to brush aside his latest warning. Unfortunately, a respected stock market indicator just sounded an alarm that lends credence to the casino analogy -- and it could signal trouble for Wall Street in the years ahead.

The S&P 500 sounds an alarm for the first time since the dot-com crash

In 1988, economist Robert Shiller introduced the cyclically-adjusted price-to-earnings (CAPE) ratio as a means of evaluating entire stock market indexes. The traditional price-to-earnings ratio can be distorted by cyclical changes in earnings; the CAPE ratio eliminates that noise by averaging inflation-adjusted earnings from the past decade.

The S&P 500 recorded an average CAPE ratio of 41.1 in August. That is well above the 30-year average of 29 and represents the highest valuation for the S&P 500 since September 2000, when the CAPE ratio reached 41.9. That reading came around the time the dot-com crash began spreading beyond the technology sector into the broader stock market.

Unfortunately, the index's rich valuation hints at a substantial downside. The chart below shows the S&P 500's best, worst, and average returns over different time periods after recording a monthly CAPE ratio above 40.

| Time Period | S&P 500’s Best Return | S&P 500’s Worst Return | S&P 500’s Average Return | |---|---|---|---| | 1 Year | 16% | (28%) | (3%) | | 2 Years | 8% | (43%) | (19%) | | 3 Years | (10%) | (43%) | (30%) |

There are two important data points in the chart. First, the S&P 500 has never posted a positive three-year return after recording a monthly CAPE ratio above 40. Second, if the S&P 500's future returns match the historical average, the index will drop 19% by August 2028 and 30% by August 2029.

Of course, past performance is never a guarantee of future results. More importantly, the CAPE multiple is a backward-looking indicator, meaning it does not account for the possibility that S&P 500 earnings grow more quickly in the future as the AI revolution boosts efficiency and productivity.

As mentioned, S&P 500 earnings are forecast to increase faster in 2026 than in any other year in the last three decades, excluding post-recession recoveries. If AI leads to sustained increases in efficiency and productivity, earnings growth could remain elevated for years to come.

In that scenario, the stock market could keep moving higher while its valuation becomes less extreme over time. Regardless, it would be foolish to ignore this warning entirely. Now is a good time for investors to build an above-average cash position. Doing so will give them the flexibility to take advantage of future drawdowns.

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Trevor Jennewine 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.