Understanding the S&P 500’s Recent Underperformance
The S&P 500 (SNPINDEX: ^GSPC) is often viewed as the gold standard for U.S. stock market benchmarks. This index tracks 500 of the largest publicly traded companies in the United States, making it a key indicator of overall market health. However, this year, the S&P 500 has seen its sharpest underperformance against global markets—excluding U.S. stocks—since 1995. A key reason behind this trend is the current state of U.S. equity valuations, which are hovering near the upper end of historical averages, according to a recent warning from the Federal Reserve.
The Federal Reserve’s Caution
The Federal Reserve does not explicitly set monetary policy with asset prices in focus, nor does it profess to know what the appropriate price for any particular asset might be. However, Fed Chairman Jerome Powell pointed out that equity prices are currently "fairly highly valued." The minutes from the January Federal Open Market Committee (FOMC) meeting echoed this sentiment, highlighting elevated asset valuation pressures and historically low credit spreads.
The credit spread, which is the extra yield investors receive for taking on corporate bond risk over U.S. Treasuries, fell to 71 basis points (0.71%) in late January. This marks the lowest level since the dot-com bubble of 1998. A narrow credit spread typically signals a high level of investor confidence in the companies issuing these bonds, yet it also raises the question of whether that confidence borders on complacency.
Complacency Among Investors
This situation evokes memories of the late 1990s when investors showed excessive optimism towards many technology companies during the internet boom. Today, similar sentiments are seen around technology companies involved in artificial intelligence (AI). While it doesn’t necessarily indicate we’re in a bubble akin to the dot-com era, the S&P 500 is indeed trading at expensive valuations by historical standards.
Price-to-Earnings Ratios
The forward price-to-earnings (P/E) ratio for the S&P 500 has been largely above 22 since July 2025, significantly exceeding the 10-year average of 18.8. Over the last four decades, such elevated P/E levels have only been sustained during two notable periods—each eventually culminating in bear markets:
-
The Dot-com Bubble: In 1998, the forward P/E ratio surpassed 22 and peaked above 24 in 1999 as investors rushed into unprofitable tech startups. This bubble burst by late 2002, leading to a staggering 49% drop in the index.
- The COVID-19 Pandemic: During 2020, the S&P 500’s P/E ratio also soared past 22, exceeding 23 as market participants underestimated the pandemic’s effect on economic activity. By late 2022, a 25% decline ensued as the Federal Reserve raised interest rates to tackle soaring inflation.
What Investors Should Consider Today
Currently, the S&P 500 appears historically expensive, and credit spreads are at an all-time low. While these factors don’t guarantee an impending bear market, they do raise alarms. Should the economic landscape worsen and credit spreads widen, companies could face increased borrowing costs, impacting profit margins negatively.
In such a scenario, earnings may not grow as rapidly as Wall Street anticipates. Given the S&P 500’s already high valuations, this could result in steep declines in stock prices.
Many experts recommend taking a proactive approach rather than liquidating entire portfolios. It may be wise to focus on "high-conviction" investments—companies expected to show robust earnings growth in the next five years—provided they are trading at reasonable multiples.
Important Takeaways for Potential Investors
Before diving back into the S&P 500 Index, investors should carefully evaluate their options. Many financial analysts suggest seeking stocks that actually provide better long-term growth potential than those currently represented in the index. For instance, the Motley Fool Stock Advisor has recently identified ten stocks they believe are poised for significant future growth, emphasizing that these aren’t the typical large-cap stocks within the S&P 500.
Historically, examples like Netflix and Nvidia, which returned over $400,000 and $1,163,635 respectively on a mere $1,000 investment, demonstrate the potential for high returns outside the S&P 500, when selected wisely.
In summary, with the stock market sounding cautionary alarms from various fronts, it’s crucial for investors to conduct thorough research and consider alternative investments that promise strong growth without the inflated valuations associated with the broader index.
