There's a number that has veteran investors quietly concerned: 40. The cyclically adjusted price-to-earnings ratio, known as the CAPE ratio or Shiller P/E, has been hovering in the 39-40 range recently and closed 2025 slightly above the 40 threshold. That's only the second time in the history of the American stock market that this widely-watched valuation gauge has crossed that level.

The first time? The late 1990s, during the peak of the dot-com bubble, when the CAPE eventually reached 44 before the spectacular crash that followed.

For investors trying to position portfolios in 2026, this rare signal deserves careful consideration—along with the important caveats that prevent it from being a simple timing tool.

What the CAPE Ratio Measures

Developed by Nobel laureate Robert Shiller, the CAPE ratio divides the S&P 500's price by its average inflation-adjusted earnings over the previous 10 years. This long averaging period smooths out business cycle fluctuations, providing what Shiller argues is a more reliable picture of underlying valuations than a simple one-year P/E ratio.

The historical average CAPE ratio sits around 17. A reading above 25 has historically signaled elevated valuations, while readings above 30 are considered extremely high by historical standards. Current levels above 40 are virtually unprecedented.

What History Shows

When the Shiller P/E runs this hot, subsequent market returns have typically disappointed. Research shows:

  • 10-year returns: Starting from CAPE levels above 25, average annual S&P 500 returns over the following decade have been in the low single digits
  • Starting from 40: The only comparable period—the late 1990s—was followed by a lost decade where stocks went essentially nowhere
  • Downside risk: Elevated CAPE readings have historically preceded the market's largest drawdowns

"When the Shiller P/E runs anywhere near this hot, it has typically been followed by a sharp reversal, though the timing of that reversal has varied widely."

— Market analyst observation

Why This Time Might Be Different

Before rushing to sell, investors should consider several factors that complicate the CAPE's message:

Interest rates: The CAPE was developed in a higher-rate era. Today's interest rate environment, while higher than the near-zero levels of recent years, remains historically moderate. Lower rates can justify higher equity valuations by making future earnings more valuable.

Composition changes: The S&P 500 today is dominated by high-margin technology companies that arguably deserve premium valuations. The index's composition differs dramatically from historical periods.

Accounting changes: Write-offs, goodwill impairments, and changes in accounting rules have affected reported earnings in ways that may artificially inflate the CAPE in recent decades.

Structural shifts: Corporate profit margins have expanded meaningfully since the 1990s, potentially justifying higher valuations on a sustainable basis.

The Bear Case

That said, dismissing the CAPE warning entirely carries its own risks:

Mean reversion: Valuations have historically reverted to long-term averages. The question is when, not if. A return to the historical average CAPE of 17 would imply a roughly 57% decline in stock prices—though such an adjustment could theoretically occur through earnings growth rather than price declines over a long enough period.

Concentration risk: Much of the S&P 500's valuation is driven by a handful of mega-cap technology stocks. If sentiment toward these companies shifts, the impact could be dramatic.

AI expectations: Current valuations embed significant optimism about artificial intelligence transforming corporate profits. If AI fails to deliver on these expectations, a repricing could be severe.

What Smart Investors Are Doing

Rather than making all-or-nothing bets, sophisticated investors are taking nuanced approaches to elevated valuations:

Diversification: International stocks, particularly in emerging markets and developed Europe, trade at significantly lower valuations than U.S. equities. Increasing international allocation provides valuation diversification.

Factor tilts: Value stocks trade at historically wide discounts to growth stocks. Small-cap value, in particular, offers exposure to segments of the market that aren't driving the elevated CAPE reading.

Quality focus: Within U.S. stocks, emphasizing companies with strong balance sheets and stable earnings can provide downside protection if valuations contract.

Rebalancing discipline: Maintaining target allocations through regular rebalancing naturally involves selling appreciated assets and buying undervalued ones.

The Bottom Line

The CAPE ratio crossing 40 is a genuinely rare event—one that merits attention without demanding panic. History suggests long-term returns from these levels are likely to disappoint, but history also shows that elevated valuations can persist longer than skeptics expect.

For most investors, the appropriate response is not market timing but rather ensuring their portfolio is properly diversified, their time horizon is realistic, and their expectations are calibrated to a potentially lower-return environment. The CAPE ratio won't tell you when to sell, but it can inform how much risk you're taking—and whether that risk is adequately compensated.

The market can remain expensive longer than you can remain patient, but it rarely stays this expensive forever.