Is the S&P 500 dangerously overvalued? Yes and no!

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The S&P 500 — the main US market index — has had a terrific run. Over the past five years, the index has gained 2,281.24 points to 4,445.93 as I write. In other words, it’s more than doubled (+105.4%) in half a decade. And that’s before adding in dividends. That’s a capital return of almost 15.5% a year compounded. This is way above the S&P 500’s long-term average yearly return. And that’s what worries me today.

The S&P 500 doubles since Meltdown Monday

The S&P 500 ended 2019 at 3,230.78, roughly 10 points below its 2019 (and all-time) high. That was a great year, with the index leaping by 28.9%. 2020 saw a positive start, with the index peaking at 3,393.52 on 19 February. But then came Covid-19 and we all know what happened next. As coronavirus spread worldwide, global stock markets crashed hard.

On ‘Meltdown Monday’ (23 March 2020), the S&P 500 hit an intra-day low of 2,191.86, before recovering to close at 2,237.40. From 2020’s top to bottom, the US index lost 35.4% of its value. Ouch! However, optimism soon returned and the index staged a comeback worthy of Lazarus. From 2020’s low to today’s 4,445.93, it has added over 2,250 points. That’s an outstanding return of 102.8% in under 19 months. In 35 years of following financial markets, this is the most powerful rebound I’ve ever seen. Indeed, it’s added close to $20trn to global wealth. Wow.

Is the index overvalued today?

When I worry about market valuations, I look to ‘Uncle Warren’ for guidance. Warren Buffett, billionaire investor and philanthropist, once wisely advised investors to “be fearful when others are greedy, and greedy when others are fearful”. The more investors suffer from euphoria, the more anxious I get about over-stretched valuations. However, Buffett also gave this advice earlier this year: “Never bet against America.” I’m worried that the S&P 500 has gone too far, too fast, but what I can do about it?

I turned to this website, which analyses whether the US market/S&P 500 is undervalued, fairly valued, or overvalued. To do this, it uses five core valuation models. These are: the US Treasury yield curve (fairly valued), valuation versus US economy size (strongly overvalued), price/earnings ratio (strongly overvalued), mean reversion (strongly overvalued), and interest rates (fairly valued). Two of these models suggest US stocks have never been so highly valued. As for me, I’m strongly convinced that the S&P 500 index is overvalued and will eventually tumble. But how do I actually act on my belief?

I’m buying cheap UK stocks

Uncle Warren told me never to bet against the USA, so I’m not going to sell my US stocks and walk away. After all, if I’m wrong and a wall of money keeps pushing the S&P 500 higher, then I would miss out on future gains. Likewise, I’m not going to shift my money into bonds, which I see as chronically over-priced after a 40-year bull (rising) market. What I won’t do is put any more money into US stocks for now. Why buy a high-priced asset, when I have a low-priced alternative on my doorstep? I rather like the look of cheap FTSE 100 stocks, which offer low earnings ratings and high dividend yields. Thus, it’s in the Footsie that I’ll shelter my money from the next market downturn. If I’m wrong and the S&P 500 keeps trouncing the Footsie, then so be it!

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services, such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool, we believe that considering a diverse range of insights makes us better investors.