The S&P 500 faced significant challenges earlier this year as concerns mounted among investors regarding President Donald Trump’s tariffs on imports and their potential economic impact. Tensions eased somewhat as the U.S. began negotiating with other nations and demonstrated some willingness to compromise. Meanwhile, most companies posted robust earnings, and investors remained hopeful that possible interest rate reductions could further stimulate growth.
These factors contributed to a surge in the major index, with leading technology firms and high-growth companies—like artificial intelligence leader Nvidia and software provider Palantir Technologies—driving much of the momentum. As a result, the S&P 500 has recently set new all-time highs and is currently trading close to its peak.
Despite this positive scenario, Federal Reserve Chair Jerome Powell has just issued a stark caution to Wall Street. Historical patterns provide a clear indication of what could be on the horizon for both the market and investors.
Image source: Getty Images.
The Fed's latest moves
Let’s review the Federal Reserve’s most recent actions. For several months, investors have been closely watching both economic indicators and the stock market, anticipating a new round of interest rate cuts. The Fed began lowering rates last year, starting in September, but paused until this month. On September 17, the Fed reduced its benchmark rate by 0.25 percentage points and suggested that two additional cuts could follow before year’s end.
Such policy decisions are generally welcomed by investors, as reduced interest rates tend to boost corporate profits and support broader economic expansion. Lower borrowing costs benefit businesses that rely on debt and can also ease financial burdens for consumers with mortgages or credit card balances. Therefore, the current trend of decreasing rates is advantageous for both companies and the stock market overall.
However, beneath this encouraging outlook, there may be underlying risks. In fact, Powell recently made a statement that could serve as a warning to Wall Street.
Addressing the state of financial markets, Powell remarked: "Equity prices are fairly highly valued." Although he clarified that this isn’t currently "a time of elevated financial stability risks," his message was unmistakable—stocks are now expensive.
The S&P 500 Shiller CAPE ratio
This is evident in the S&P 500 Shiller CAPE ratio, which adjusts stock prices for inflation and compares them to average earnings over the past decade. This year, the ratio has surpassed 37 on two occasions—a level reached only twice before since the S&P 500 became a 500-stock index in the late 1950s.
So what might happen next? Looking back, every time the Shiller CAPE ratio has climbed this high, the S&P 500 has subsequently experienced a decline.
S&P 500 Shiller CAPE Ratio data by YCharts.
Sometimes, these downturns have been brief corrections; in other cases, it has taken the index longer to recover and move higher. If past trends are any indication, with stocks at such elevated valuations, the S&P 500 may be poised for a pullback.
The silver lining
But before you become anxious about potential losses in your portfolio, there are reasons to remain calm. First, the timing of a market drop is uncertain—it could occur soon, or it might not happen for another year—and any decline could be short in duration. Therefore, the immediate risk may be limited, and the impact could be relatively mild when it does occur.
More importantly, history demonstrates that any significant market downturn is temporary. After each decline, including major crashes, the S&P 500 has always rebounded and eventually reached new highs. We have witnessed these record levels again in recent days.
This is excellent news for those investing for the long term. Even if your portfolio temporarily declines during a market drop, holding onto your investments increases the likelihood of recovery and long-term gains. This perspective should provide reassurance, even in light of Powell’s recent warning to Wall Street.
