S&P 500 Poised For A 40% Crash?

Let’s begin with a difficult truth: the Shiller PE ratio of the S&P 500 is currently just under 40. If you’re curious as to why this should alarm you, let’s place it within a historical framework.

What exactly is the Shiller PE telling us? The Shiller PE — also referred to as the Cyclically Adjusted PE Ratio (CAPE) — takes the current value of the benchmark index and divides it by the 10-year average of inflation-adjusted earnings of index components, which helps to mitigate the effects of business cycles and offers a clearer view of sustainable earning potential. When this ratio reaches extreme heights, it indicates that investors are paying excessively for each dollar of historical earnings.

Here’s an essential inquiry: How extreme is a Shiller PE of 40?

Nobel prize winner Robert Shiller voiced his concerns in 2014 when the figure surpassed 25, highlighting this as “a level that has only been exceeded since 1881 during three past periods: the years surrounding 1929, 1999, and 2007.” And what transpired after each of those peaks? Catastrophic market crashes.

We will explore the details in the following sections. However, if these valuation worries lead you to reconsider your broad market exposure, some strategies could potentially offer upside with less volatility compared to holding individual stocks or navigating the full beta of the S&P 500. Consider the Trefis High Quality Portfolio. It has significantly outperformed its benchmark—a combination of all 3, the S&P 500, Russell, and S&P MidCap indices—and has generated returns exceeding 105% since its inception. Why is this the case? As a group, HQ Portfolio stocks have provided improved returns with less risk compared to the benchmark index; less of a roller-coaster experience, as demonstrated in HQ Portfolio performance metrics.

When The Shiller PE Exceeds 32, The Precedents Are Alarming

So what transpired the last 3 times the Shiller PE reached levels above 32:

[1] 1929: The Great Depression

In September 1929, the Shiller PE ratio climbed to nearly 32.6, and the notorious stock market crash followed the next month. The result? The S&P 500 dropped over 83% during the Great Depression, while the Dow eventually fell 89% from its peak to its lowest point in the summer of 1932. Even more concerning: An investor who entered the market at the previous high on August 31, 1929, would have suffered negative returns for more than 25 years until September 1945 (excluding dividends).

[2] 2000: The Dot-Com Bubble

The Shiller PE ratio achieved an all-time high of 44.19 in December 1999, just before the technology bubble burst. What was the outcome? From its apex on March 24, 2000, to its trough on October 9, 2002, the S&P 500 declined by 49%.

For perspective on how drastic market downturns can be, our dashboard – How Low Can Stocks Go During A Market Crash – illustrates how key stocks performed during and after the last seven market crashes, providing insight into potential recession scenarios.

[3] 2021-2022: The Post-Pandemic Correction

The Shiller PE ratio peaked at approximately 38.6 in late 2021 — the second-highest reading in history following the dot-com bubble. From its high of 4,796 on January 3, 2022, the S&P 500 fell 25% to its low in October 2022. The index officially entered bear market territory in June 2022, declining more than 20% from its high. For the entire year of 2022, the S&P 500 recorded a decline of approximately 19%, marking its poorest performance since 2008. Also, see – How Low Can NVIDIA Stock Really Go?

What Does This Imply for Today’s Market?

If we take these historical benchmarks and apply them to today’s S&P 500 (standing at 6,671 as of October 15, 2025), the possible downside becomes disturbingly apparent:

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

It’s notable that the 2022 correction took place at a Shiller PE level almost identical to what we see today. Despite that shock less than 3 years ago, market valuations have now risen even further! Even if we consider that we might face a moderate correction similar to the one witnessed in 2022, one fact is undeniable: when valuations hit these extremes, the market typically reverts toward its long-term average.

A Symphony of Risk Factors

However, extreme valuations are not acting in isolation. Today’s market confronts a troubling confluence of challenges:

1. Persistent Inflation: In spite of the Federal Reserve’s efforts, inflation remains stubbornly above Fed’s 2% target. So what? This limits the Fed’s capacity to bolster markets through rate reductions. See our analysis on – Will Inflation Data Crush The S&P 500?
2. High Interest Rates: With rates remaining elevated by recent historical standards, the cost of capital continues to hinder corporate profitability and makes risk-free Treasuries more attractive compared to equities.
3. Trade War Uncertainties: Renewed protectionist policies and threats of tariffs are generating uncertainty for multinational corporations and global supply chains.
4. Immigration Policies: Possible labor market disruptions stemming from restrictive immigration policies can intensify wage pressures and inflation.
5. Rising US Debt: With federal debt nearing unprecedented peacetime levels, concerns surrounding fiscal sustainability and potential credit consequences are becoming more pronounced. Related – The Great Debt Divide: Government vs. The Tech Giants
6. Flourishing Alternative Assets: Gold is trading above $4,200 per ounce (an increase of over 25% in 2025), and Bitcoin is sitting around $111,000 near its historic highs. The strong performance of these alternative assets presents viable options for capital flight if equity valuations contract, undermining the “There Is No Alternative” narrative that has traditionally supported stock prices.

These risks are not isolated—they are interconnected threats that have the potential to amplify one another. A rise in inflation induced by tariffs may compel the Fed to maintain higher rates for an extended period, putting pressure on corporate margins as government debt service costs increase. It’s a cacophony of negative factors that could hit the markets hard, especially when starting from such inflated valuations.

The Bull Case: Why We May Be Mistaken

Nonetheless, below we outline scenarios where the bearish view could be incorrect, and why markets might continue to rise:

“This Time Is Different” Arguments:

1. The Technology Revolution: AI, quantum computing, and biotechnology could facilitate genuine productivity increases that validate higher valuations. If corporate earnings surge due to technological advances, earnings will catch up – making today’s PE ratios look justifiable in hindsight.
2. International Capital Flows: As global investors seek safety and yields, US markets may continue to attract capital inflows that uphold elevated valuations regardless of conventional metrics.
3. Corporate Buybacks: With companies holding substantial cash reserves and actively pursuing share buyback programs, there remains strong technical support for stock prices. For example, see – The GOOGL Stock Shareholder Jackpot
4. The Fed Safety Net: Markets have become accustomed to the belief that the Federal Reserve will ultimately step in to avert severe downturns, establishing an implicit floor under valuations.
5. Shifting Market Composition: Today’s S&P 500 is dominated by asset-light, high-margin technology firms rather than the capital-intensive industries of past decades. Perhaps historical valuation metrics simply do not apply to the modern economic landscape.
6. Demographic Shifts and Retirement Flows: As baby boomers increasingly transition into retirement portfolios that prioritize equity allocations, enduring demand has the potential to sustain prices.

The Ruling: Quantifying the Downside Risk

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

Here’s the rationale:

• Historical crashes from comparable Shiller PE levels typically averaged around 50% declines
• Current macroeconomic conditions (debt levels, geopolitical stresses, inflation) arguably present more systemic risks than in 2000, although perhaps lower leverage than in 2007.
• The combination of extreme valuations along with multiple economic challenges creates the conditions for a “perfect storm” scenario
• However, modern circuit breakers, more advanced Fed tools, and international policy coordination may prevent the worst-case scenarios

A detailed breakdown:

Timeline considerations: Out of 21 significant market declines since 1950, the Shiller PE Ratio issued warnings for 10 of these by breaching its long-term average. While the ratio isn’t a precise timing tool, historical patterns imply elevated risk within a 1-3 year timeframe.

How should investors position themselves in this climate?

In light of the considerable downside risks highlighted above, investing in a single stock without thorough analysis can be especially hazardous when overall market valuations are stretched. Under such circumstances, diversification and systematic approaches are vital.

Consider strategies such as the Trefis Reinforced Value (RV) Portfolio, which has surpassed its all-cap stocks benchmark (a combination of the S&P 500, S&P mid-cap, and Russell 2000 benchmark indices) to yield strong returns for investors. Why is this so? The quarterly rebalanced mix of large-, mid-, and small-cap RV Portfolio stocks provided a responsive solution to leverage favorable market conditions while mitigating losses when markets decline, as detailed in RV Portfolio performance metrics. In the face of a potential 40-60% downside, strategies that can “limit losses when markets head south” are especially crucial.

The Bottom Line

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

What’s certain is this: investors at today’s valuations are paying remarkably high prices in relation to historical norms. Whether this price is warranted by a truly new paradigm or signifies yet another chapter in the timeless narrative of speculative excess will only become clear in hindsight.

The prudent approach? Recognize the risk, size positions appropriately, and keep liquidity for opportunities. Overall, it would be wise to exercise a degree of caution and refrain from absolute certainty in any one direction. Those who display the greatest confidence often find themselves at the highest risk of being caught off guard.