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Written by Matt DiLallo for The Motley Fool
The Shiller CAPE Ratio is at its second-highest point in history.
The S&P 500 has historically endured a major correction when this ratio has hit a notable peak.
Companies that steadily grow their dividends have historically been much less volatile during major market downturns.
The Shiller CAPE Ratio -- a measure of how expensive stocks are compared to a decade of earnings -- recently hit its highest level since the dot-com era, the only other time it has been this high. The last time this happened, the S&P 500 Index (SNPINDEX:^GSPC) lost about half its value over the next two and a half years.
I'm not predicting that this means we'll endure another dot-com-style crash. What I want to do instead is point investors to the investments that have historically performed well during market downturns: Dividend stocks. I'll also showcase an investment that should help provide your portfolio some ballast if we experience a meaningful correction in the coming months.
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American economist Robert Shiller invented the Shiller CAPE Ratio (cyclically adjusted price-to-earnings ratio) to gauge whether the market was undervalued or overvalued compared to its historical inflation-adjusted earnings record. The data supporting this ratio goes back 150 years. It peaked in late 1999 at 44.19.
The S&P 500 would go on to top out a few months later in March 2000 at 1,527.5. It subsequently lost 49% of its value over the next two-and-a-half years, bottoming at 776.8 in October 2002. It took the index nearly five years to regain its former peak.
Here's why that historical precedent is a little unnerving. The Shiller CAPE ratio recently hit 41.3, its highest level since the dot-com era. The index also hit notable peaks in October 2021 (38.6) and July 1929 (31.5), both of which preceded meaningful market corrections.
Given that historical precedent, it makes sense to give some serious consideration to the current elevated reading. However, instead of cashing out your portfolio in hopes of avoiding a crash that might never come, I wanted to offer an alternative to help cushion it during a major downturn.
Dividend stocks, particularly companies that steadily increase their dividends, have proven much less volatile over the long term, especially during market sell-offs. S&P Dow Jones Indices has tracked the performance of Dividend Aristocrats® (the term Dividend Aristocrats® is a registered trademark of Standard & Poor's Financials Services LLC and measures the performance of S&P 500 members with 25 or more years of annual dividend increases) over the years. It found that this group of dividend stocks outperformed the S&P 500 during the period following the dot-com crash (10.2% vs. -9.1% in 2000, 10.8% vs. -11.9% in 2001, and -9.9% vs. -22.1% in 2022). They also declined less than the broader market index during the 2008-2009 financial crisis (-21.9% vs. -37%) and the 2022 rate-hike-driven stock market slump (-8.5% vs. -19.4%).
You can invest directly in this elite group of dividend stocks through the ProShares S&P 500 Dividend Aristocrats® ETF (NYSEMKT:NOBL). This ETF aims to measure the performance of S&P 500 companies that have consistently increased their dividend for at least 25 years. That list currently includes 69 companies. The ETF specifically notes on its website that its holdings have historically captured most of the market's gains when it rises, with less severe drawdowns and lower volatility compared to the S&P 500. The fund currently offers a 2% dividend yield, double the S&P 500's current level.
While there's no guarantee that NOBL will experience a less severe decline compared to the S&P 500 during the next market correction, history isn't the only factor on its side. The S&P 500 is currently at its most concentrated point since 1965, with its top 10 holdings comprising nearly 40% of its value, well above its dot-com peak of 26%. All of its top holdings are tech or tech-adjacent stocks that are heavily reliant on AI to drive growth. Contrast that with NOBL. Its top 10 holdings only comprise 17% of its value, while tech is a small percentage of its total holdings (less than 3%). That makes it a good complement to an S&P 500 index fund these days, as it provides more diversification. If AI stocks slump, NOBL's holdings should hold up much better.
The Shiller CAPE ratio is at one of its highest points in history. That should at least give you some reason to consider whether it's time to add more ballast to your portfolio, which dividend growers have historically done. Investing in NOBL is an easy way to add some of the highest-quality dividend growth stocks to your portfolio while providing meaningful diversification relative to the S&P 500.
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Matt DiLallo has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends ProShares S&P 500 Dividend Aristocrats ETF. The Motley Fool has a disclosure policy.