History says the stock market is likely to decline (perhaps sharply) in the years ahead.
The S&P 500 (^GSPC +0.05%) has advanced nearly 80% over the last three years, but the stock market and bond market recently flashed warnings not seen since the dot-com era. Those warnings suggest that investors are caught in a high-risk, low-reward environment.
Here are the important details.
Image source: Getty Images.
The bond market flashes a warning last seen ahead of the dot-com crash in 1998
In late January, the spread between investment-grade corporate bonds and U.S. Treasury bonds narrowed to 71 basis points, according to Bloomberg. That means the average yield on quality corporate debt was just 0.71% higher than the average yield on Treasuries with corresponding maturities.
Credit spreads have not been that tight since 1998. Put differently, not since the dot-com bubble has demand for investment-grade corporate bonds been so immense that investors accepted such a low risk premium.
What’s the problem? Treasuries are considered risk-free because even the most financially stable business in the world is (arguably) more likely to default than the U.S. government.
So, there are two ways to interpret the situation. Investors are very confident that companies issuing quality debt (usually to build artificial intelligence infrastructure) will not default. But investors may be too complacent, in which case anything that disrupts the narrative could have profoundly negative consequences for bonds and stocks.
Consider this scenario: If the economic outlook deteriorates (perhaps due to tariffs), demand for corporate debt could fall sharply, causing bond prices to fall and yields to rise. In turn, the stock market could fall sharply because companies would have to pay more to borrow money, which would cut into profits.
The credit spread between investment-grade corporate bonds and Treasuries is at its tightest level in nearly three decades. That leaves investors in a high-risk, low-reward environment. There is little room for upside because credit spreads can hardly tighten further, but there is plenty of downside risk if the economy stumbles.
The stock market flashes a warning last seen during the dot-com crash in 2000
The cyclically adjusted price-to-earnings (CAPE) ratio was developed by Nobel Laureate Robert Shiller and Harvard professor John Campbell. It measures the valuation of the stock market by dividing its current level by the average inflation-adjusted earnings from the past decade.
The S&P 500 recorded an average CAPE ratio of 40.1 in January 2026, the highest reading since the dot-com crash in September 2000. The index’s monthly CAPE ratio has only been that high 22 times since it was created in 1957 (829 months ago), meaning the stock market has been so expensive less than 3% of the time in history.
Historically, CAPE ratios above 40 have correlated with modest declines during the next year and steep losses over the next several years. The table shows the S&P 500’s best, worst, and average performance over different time periods following CAPE readings above 40.
|
Time Period |
S&P 500’s Best Return |
S&P 500’s Worst Return |
S&P 500’s Average Return |
|---|---|---|---|
|
One year |
16% |
(28%) |
(3%) |
|
Two years |
8% |
(43%) |
(19%) |
|
Three years |
(10%) |
(43%) |
(30%) |
Data source: Robert Shiller. Table by author.
Here’s what the table says about the future: If the S&P 500’s performance aligns with the historical average, the index will drop 3% by February 2027, 19% by February 2028, and 30% by February 2029. The table also says there is no chance of a positive return in the next three years, even in the best-case scenario.
Of course, past performance is never a guarantee of future results. The CAPE multiple is a backward-looking valuation measure, meaning it does not contemplate the possibility that artificial intelligence will boost profit margins. In that scenario, forward earnings could increase fast enough that the S&P 500 keeps rising while the CAPE ratio falls to a more modest level in coming years.
Nevertheless, the current market environment warrants caution. The S&P 500 trades at the high end of its historical valuation range, meaning the stock market’s risk-reward profile is skewed toward risk. Now is a good time to sell any stocks you would feel uncomfortable holding through a steep drawdown, and you should limit stock purchases to your highest-conviction ideas.
