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Should You Buy an S&P 500 Index Fund at All-Time Highs?

Last week, the S&P 500 index (^GSPC 0.70%), composed of the 500 largest U.S. companies by market cap, hit yet another all-time high, reaching $5,341.88 intraday on Thursday, May 23.

An S&P 500 index fund has long been touted by Warren Buffett as his favorite investment for those who don’t have the time to study individual stocks closely. And last week’s milestone certainly seems to justify that thesis.

But with the stock market recently hitting a fresh all-time high, AI enthusiasm perhaps getting a bit bubbly, and interest rates and inflation remaining stubbornly higher than we’d like, is it really a good time to be buying the S&P 500 today?

The case against buying the S&P 500 here

For those cautious on the markets, you can find plenty of good reasons to hold off on buying the stock market averages. For one, the S&P, as a market-cap weighted index, is dominated by large technology companies which have gone up a tremendous amount recently, as part of a bull market that has lasted really since October of 2022.

The combination of interest rates appearing to top out, inflation having decreased from its peak of 9.1% in June of 2022 to just 3.4% last month, and tailwinds from the artificial intelligence boom have spurred large technology companies to fresh new heights.

And new highs aren’t just being reached by Nvidia (NVDA 2.57%), which just reached an eye-watering market cap of $2.6 trillion with a high P/E ratio of 62. Most of the cloud giants, as well as associated semiconductor stocks have also rocketed higher on the back of strong perceived growth that will carry on into the future indefinitely.

But will it? After all, AI investment will have to justify its end benefits to companies and consumers, and companies are now spending unprecedented amounts on AI chips and data centers out of fear of being left behind. Sound familiar? This current boom has faint echoes of the dot-com buildout in the late 1990s, which saw several boom years as internet mania took hold, only for the bubble to burst in 2000. That bursting led to an epic crash and recession, causing an unprecedented three consecutive years of declines for the tech-heavy Nasdaq Composite, which declined by an epic 76.8% from peak-to-trough, while the S&P 500 fell a more mild but still nauseating 49.1%.

Could the AI bubble burst in a similar fashion? AI momentum certainly doesn’t appear to be stopping anytime soon. But on the other hand, few saw the crash of 2000 coming either, believing internet hypergrowth would last forever and not revert back toward the growth rate of GDP. Someday, it’s likely that there will be an AI company that reports a slowdown or digestion in growth, and these high-flying stocks could correct in a big way. Will that day occur soon? Probably not, but it’s hard to tell.

Meanwhile, inflation affects what the Federal Reserve will do with interest rates, and higher interest rates tend to depress stock valuations as well as the economy. With inflation remaining somewhat “sticky,” and disappointing to the upside of expectations over the past couple months, it’s possible the Federal Reserve may have to keep interest rates higher for longer in order to reach it’s 2% inflation target.

That could be a problem, as the S&P 500 trades at an historically above-average valuation. Today, the S&P 500 index currently trades at 27.6 times trailing earnings. That’s actually quite high by historical standards, as the average valuation for the index over the course of history is 16.1.

So if interest rates and inflation surge again, it could certainly be a dangerous time to invest in this frothy market.

The case for buying the S&P 500

On the other hand, as famed investor Peter Lynch once said, “there is always something to worry about” in markets.

While the average P/E ratio of the S&P 500 over the course of market history is much lower than today’s, the market has tended to trade at a higher P/E ratio in recent years. In fact, the average is around 22.5 over the past 10 years. While below today’s prices, that’s still much closer. Meanwhile, had you sat out of investing in the stock market over the past decade on fears of high valuations, you would have missed out on 236% gains, including dividends, over that time.

^SPXTR data by YCharts

Furthermore, the average returns of the S&P 500 since 1928 through 2023, when the Standard & Poor’s index was first developed, is around 9.9%, with dividends reinvested. And since the index formally expanded to 500 companies in 1957, the long-term annualized return has been an even better 10.3%.

Of course, there have been several specific moments just on the cusp of huge market crashes when one might not have wanted to invest. However, a study by Ben Carlson, author of the blog A Wealth of Common Sense, points out that if your time horizon is long enough, even investing at market peaks just before stock market crashes have still paid off over the long run. Carlson looked at returns of theoretical investments made right before eight of the market’s worst crashes, from September of 1929 to October of 2007, before the Great Recession of 2008.

Looking five years out, three of those investments would have still yielded positive results. 10 years out, six of those eight investments would have been profitable, with three yielding triple-digit gains. And 20 years after investing at the eight very worst possible times in market history, all eight would have been profitable, with returns for every investment except September 1929 yielding multi-hundreds-of-percent gains.

Stick to your stock plan

Of course, prudent investing doesn’t only amount to one-time, large investments. Rather, if you save a portion of your income and dollar-cost-average into an index fund every month, yes, you’ll invest before some market peaks, but you’ll also average that out by investing in subsequent downturns.

Market crashes are extremely difficult, if not impossible, to predict. But as we’ve seen from history, even investments made before the worst market peaks and crashes eventually heal themselves, as the earnings of American business grows over time. Meanwhile, trying to time the market can cost you big-time, as we’ve seen from those who have sat out of the market for the past 10 years.

Therefore, the S&P 500 appears to be a fine buy today, even at its elevated valuation, provided that you have a consistent investing plan and stick with regular monthly, quarterly, or annual allocations.

This post appeared first on fool.com

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