The Coming Storm? A Sobering Look At S&P 500 Downside Risk

Let’s start with an uncomfortable truth: the S&P 500’s Shiller PE ratio is just under 40 right now. If you’re wondering why that should worry you, let’s put it in historical context.

What exactly is the Shiller PE telling us? The Shiller PE — also called the Cyclically Adjusted PE Ratio (CAPE) ratio — divides the current value of the benchmark index by the 10-year average inflation-adjusted earnings of index components, helping to smooth out business cycles and provide a clearer picture of sustainable earning power. When this ratio climbs to extreme levels, it suggests investors are paying far too much for each dollar of historical earnings.

Here’s the critical question: How extreme is a Shiller PE of 40?

Robert Shiller expressed concern in 2014 when the figure exceeded 25, noting this was “a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999, and 2007.” And what followed each of those peaks? Devastating market crashes.

We’ll delve into the details in the sections below. But if these valuation concerns have you questioning your broad market exposure, some strategies can potentially deliver upside with less volatility than holding individual stocks or riding the full beta of the S&P 500. Consider the Trefis High Quality Portfolio. It has comfortably outperformed its benchmark — a combination of the S&P 500, Russell, and S&P MidCap indexes — and has achieved returns exceeding 105% since its inception. Why is that? As a group, HQ Portfolio stocks provided better returns with less risk versus the benchmark index; less of a roller-coaster ride, as evident in HQ Portfolio performance metrics.

Image by Horst Schwalm from Pixabay

When The Shiller PE Crosses 32, The Precedents Are Chilling

Let’s examine what happened the last 3 times the Shiller PE moved to levels above 32:

1929: The Great Depression

In September 1929, the Shiller PE ratio reached nearly 32.6, and the infamous stock market crash occurred the next month. The aftermath? The S&P 500 plummeted over 83% during the Great Depression, with the Dow ultimately falling 89% from its peak to its summer 1932 bottom. Even more sobering: An investor at the previous high on August 31, 1929, would have experienced negative returns for over 25 years until September 1945 (not accounting for dividends).

2000: The Dot-Com Bubble

The Shiller PE ratio reached its highest-ever level of 44.19 in December 1999, right before the technology bubble burst. What followed? From its peak on March 24, 2000, to its low on October 9, 2002, the S&P 500 fell 49%.

For context on how severe market downturns can become, our dashboard – How Low Can Stocks Go During A Market Crash – captures how key stocks fared during and after the last seven market crashes, providing insight into potential recession scenarios.

2021-2022: The Post-Pandemic Correction

The Shiller PE ratio ratio peaked at approximately 38.6 in late 2021 — the second-highest reading in history after the dot-com bubble. From its January 3, 2022, high of 4,796, the S&P 500 fell 25% to its October 2022 low. The index officially entered bear market territory in June 2022, declining over 20% from its peak. For the full year 2022, the S&P 500 posted a decline of approximately 19%, its worst performance since 2008.

What Does This Mean for Today’s Market?

If we apply these historical benchmarks to today’s S&P 500 (at 6,671 as of October 15, 2025), the potential downside becomes alarmingly clear:

• Great Depression scenario (83% decline): S&P 500 falls to below 1,150
• Dot-Com Bubble scenario (49% decline): S&P 500 falls to around 3,400
• The 2022-Correction scenario (25% decline): S&P 500 falls to under 5,000

Notably, the 2022 correction occurred at a Shiller PE level nearly identical to today’s. Despite that jolt less than 3 years ago, market valuations now are higher still! Even if we consider that we are in for a moderate correction along the lines of what we saw in 2022, one point is undisputable: when valuations reach these extremes, the market tends to revert toward its long-term average.

A Symphony of Risk Factors

But extreme valuations aren’t operating in isolation. Today’s market faces a troubling confluence of headwinds:

1. Sticky Inflation: Despite Federal Reserve efforts, inflation remains persistently above target, constraining the Fed’s ability to support markets through rate cuts. See our take on – Will Inflation Data Crush The S&P 500?
2. Elevated Interest Rates: With rates still high by recent historical standards, the cost of capital remains a drag on corporate profitability and makes risk-free Treasuries more competitive with equities.
3. Trade War Tensions: Renewed protectionist policies and tariff threats are creating uncertainty for multinational corporations and global supply chains.
4. Immigration Policies: Potential labor market disruptions from restrictive immigration can exacerbate wage pressures and inflation.
5. Mounting US Debt: With federal debt approaching unprecedented peacetime levels, questions about fiscal sustainability and potential credit implications loom larger. Related – The Great Debt Divide: Government vs. The Tech Giants
6. Thriving Alternative Assets: Gold is trading above $4,200 per ounce (up over 25% in 2025), and Bitcoin is hovering around $111,000 near all-time highs. The strong performance of these alternative assets provides viable destinations for capital flight if equity valuations compress, undermining the “There Is No Alternative” narrative that has historically supported stock prices.

These aren’t isolated risks—they’re interconnected threats that may reinforce each other. A tariff-induced inflation spike may force the Fed to keep rates higher for longer, squeezing corporate margins while government debt service costs spiral. It’s a harmony of bad things that can strike the markets hard, particularly when starting from such elevated valuations.

The Bull Case: Why We May Be Wrong

Well, honesty demands we consider scenarios where the bears are proven wrong. Here are compelling reasons why markets might continue climbing despite these warnings:

“This Time Is Different” Arguments:

1. The Tech Revolution: AI, quantum computing, and biotech can drive genuine productivity gains that justify higher valuations. If corporate earnings surge due to technological breakthroughs, today’s PE ratios might actually be reasonable.
2. The TINA (There Is No Alternative) Effect: With bonds offering limited real returns after inflation and other asset classes looking unattractive, equities might maintain their premium simply because investors have nowhere else to go.
3. Global Capital Flows: As international investors seek stability and returns, US markets may continue attracting capital inflows that support elevated valuations regardless of traditional metrics.
4. Corporate Buybacks: With companies sitting on substantial cash and continuing aggressive share repurchase programs, technical support for stock prices remains strong. For instance, see – The GOOGL Stock Shareholder Jackpot
5. The Fed Put: Markets have become conditioned to believe the Federal Reserve will ultimately intervene to prevent severe downturns, creating an implicit floor under valuations.
6. Changing Market Composition: Today’s S&P 500 is dominated by asset-light, high-margin technology companies rather than the capital-intensive industrials of past eras. Perhaps old valuation metrics simply don’t apply to the modern economy.
7. Demographics and Retirement Flows: As baby boomers continue shifting into retirement portfolios with equity allocations, sustained demand has the potential to support prices.

The Verdict: Quantifying the Downside Risk

The real risk of downside for the S&P 500 from current levels is 25-50%.

Here’s the reasoning:

• Historical crashes from similar Shiller PE levels averaged approximately 50% declines
• Current macroeconomic conditions (debt levels, geopolitical tensions, inflation) arguably present greater systemic risks than in 2000, though perhaps less leverage than in 2007.
• The combination of extreme valuations with multiple economic headwinds creates conditions for a “perfect storm” scenario
• However, modern circuit breakers, more sophisticated Fed tools, and global policy coordination may prevent the absolute worst-case outcomes

A more granular breakdown:

Timeline considerations: Out of 21 major market declines since 1950, the Shiller PE Ratio provided warnings for 10 of them by breaching its long-term average. The ratio isn’t a precise timing tool, but historical patterns suggest elevated risk within a 1-3 year window.

How should investors position themselves in this environment?

Given the substantial downside risks outlined above, investing in a single stock without comprehensive analysis can be particularly dangerous when broader market valuations are stretched. In such conditions, diversification and systematic approaches become crucial.

Consider strategies like the Trefis Reinforced Value (RV) Portfolio, which has outperformed its all-cap stocks benchmark (combination of the S&P 500, S&P mid-cap, and Russell 2000 benchmark indices) to produce strong returns for investors. Why is that? The quarterly rebalanced mix of large-, mid-, and small-cap RV Portfolio stocks provided a responsive way to make the most of upbeat market conditions while limiting losses when markets head south, as detailed in RV Portfolio performance metrics. When facing a potential 40-60% downside, strategies that can “limit losses when markets head south” become especially valuable.

The Bottom Line

The market often has a way of testing the confidence of its most certain participants. While the weight of historical evidence suggests significant downside risk, markets have repeatedly defied gravity when skeptics were most convinced of their demise.

What’s certain is this: investors at today’s valuations are paying extraordinarily high prices relative to history. Whether that price is justified by a genuinely new paradigm or represents another chapter in the timeless story of speculative excess will only be clear in hindsight.

The prudent approach? Acknowledge the risk, size positions accordingly, and maintain dry powder for opportunities. Overall, it will be wise to maintain a degree of humility and avoid absolute conviction in any single direction. Those who express the greatest certainty often find themselves facing the highest risk of being surprised.

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