Over the long term, Wall Street has proven to be a true creator of wealth. Although other asset classes, such as bonds and real estate, have made investors rich, nothing else comes remotely close to the average annual return that stocks have generated for more than a century.
Right now, Wall Street is enjoying new momentum bull market. Since the green flag waved at the start of 2023, the timeless Dow Jones Industrial Average (DJ CLUES: ^ DJI)reference S&P500 (SNPINDEX: ^GSPC)and fueled by growth Nasdaq Composite Index (NASDAQ INDEX: ^IXIC) rose by 18%, 43% and 71%, respectively, as of the closing bell on June 27, 2024.
But if there’s one thing that’s certain on Wall Street, it’s that stocks don’t move in a straight line. While artificial intelligence (AI) and Stock Split Euphoria As trade tensions fuel the current bull market, three predictive indicators historically highly correlated with Wall Street declines appear to foreshadow a potential stock market crash in 2024.
A historic drop in the US M2 money supply
To be clear, no measure can, with guaranteed accuracy, predict a short-term directional move in major stock indices. However, some indicators have a history of predicting declines in the Dow Jones, S&P 500, and Nasdaq Composite. The U.S. M2 money supply is one such measure.
The M2 money supply includes everything you’ll find in M1 – cash and coins in circulation, plus demand deposits in a checking account – and adds money market accounts, savings accounts, and certificates of deposit (CDs) less than $100,000. Think of M1 as money that can be spent on the spot and M2 as money that can still be spent fairly easily but requires more work to get there.
For nine decades, the M2 money supply has increased virtually without interruption. In other words, more capital was needed to circulate to support a growing economy.
ATTENTION: the money supply is officially in contraction. 📉
This has only happened 4 times in the last 150 years.
Each time, a depression with double-digit unemployment rates followed. 😬 pic.twitter.com/j3FE532oac
– Nick Gerli (@nickgerli1) March 8, 2023
But since its peak in April 2022, M2 has declined significantly. Although up 0.69% on an annual basis, the US money supply M2 has decreased by 3.49% on an overall basis since its all-time high. As you can see in Reventure Consulting CEO Nick Gerli’s article on (1878). , 1893, 1921, 1931-1933 and 2023).
The previous four cases where M2 fell by at least 2% correspond to periods of double-digit unemployment and economic depression. Although two of these cases occurred before the creation of the Federal Reserve and the probability of a depression is very low today, it must be concluded that the decrease in circulating capital leads to a decrease in discretionary purchases of consumers. In short, it’s the perfect recipe for a recession – and the stock market historically performs poorly once a recession is declared.
The longest yield curve inversion in the modern era
The second predictive tool that seems to portend trouble for Wall Street is the Treasury yield curve. Compared to the M2 money supply, it is a much more popular indicator.
Typically, the Treasury yield curve slopes upward and to the right. This means that longer-term Treasury bonds (those maturing in 10 or 30 years) have higher yields than Treasury bonds maturing in one year or less. The longer your money is tied up in an interest-bearing asset, the higher the yield should be.
Since July 5, 2022, the spread (yield difference) between the 10-year bond and the two-year Treasury note has been underwater. In other words, two-year Treasury securities have been yielding more than 10-year Treasury notes. This is called a yield curve inversion, and it is the longest in modern times.
Here’s what’s interesting about yield curve inversions: They have preceded every U.S. recession since the end of World War II. About two-thirds of the peak-to-trough declines in the S&P 500 have occurred during U.S. recessions.
However, and this is a big “However,” not every yield curve inversion has been followed by a recession. Think of yield curve inversion as a necessary ingredient that signals that the U.S. economy is facing headwinds.
Stocks are exceptionally expensive
The third predictive metric that suggests a potential stock market crash may be coming is the valuation-based Shiller price-to-earnings (P/E) ratio, also commonly referred to as the cyclically adjusted price-to-earnings (CAPE) ratio.
While the traditional P/E ratio focuses on trailing 12-month earnings, the S&P 500 Shiller P/E ratio is based on inflation-adjusted average earnings over the previous 10 years. Looking at 10-year earnings history smooths out “hiccups” (e.g., the effects of COVID-19) that might otherwise distort investors’ perception of value.
As of the close of trading on June 27, the S&P 500’s Shiller price-earnings ratio stood at 35.70. That’s more than double its average of 17.13, as backtested over the past 153 years.
The point of the Shiller price-to-earnings ratio is to examine how Wall Street’s major stock indexes reacted when it rose above 30 during a bull market. Since 1871, this has happened six times: 1) August 1929 to September 1929, 2) June 1997 to August 2001, 3) September 2017 to November 2018, 4) December 2019 to February 2020, 5) from August 2020 to May 2022 and 6) from November 2023 to today.
The previous five instances where the Shiller P/E ratio exceeded 30 ultimately caused the Dow Jones Industrial Average, S&P 500, and/or Nasdaq Composite to lose between 20% and 89% of their value.
As you can see from the dates of these six cases, there is no reason or rationale why stocks should remain expensive. What is clear is that stretched valuations do not hold up over the long term. When the S&P 500 Shiller P/E ratio rises above 30 for a period of time, it is historically a cautionary tale that a bear market and/or potential crash awaits them.
Time and perspective change everything
To reiterate, the three predictive indicators above suggest that the ingredients are there for a potential stock market crash in 2024. They do not guarantee anything. It is impossible to concretely predict what stocks will do in a week, a month, or even a year.
But when investors take a step back and broaden their perspectives, it becomes much easier to predict where stocks will collectively head.
Let’s take the business cycle as a good example. As much as workers hate the idea of slowdowns and recessions, the fact remains that they are perfectly normal. No amount of goodwill can prevent recessions from happening.
However, this boom-bust cycle for the economy is not linear. Since the end of World War II in September 1945, nine of twelve U.S. recessions have been resolved in less than a year, and none of the remaining three recessions have lasted longer than 18 months. In comparison, most periods of economic growth have lasted several years, with two expansions lasting more than 10 years. Being optimistic and betting on the growth of the American economy was undoubtedly a wise decision.
This same dynamic is playing out on Wall Street.
In June 2023, Bespoke Investment Group published the post you see above on X. It highlights the calendar duration of every S&P 500 bear and bull market since the start of the Great Depression in September 1929. What you’ll notice is that the average duration of bull markets (1,011 calendar days) for the S&P 500 is about 3.5 times longer than the typical S&P 500 bear market (286 calendar days).
Additionally, nearly half of the S&P 500 bull markets (13 out of 27) lasted longer than the longest bear market over a 94-year period.
A comprehensive data set from Crestmont Research investment advisors adds to the value of time and perspective. Crestmont analysts calculated rolling 20-year total returns for the S&P 500, including dividends, when back-testing back to 1900. This research resulted in 105 rolling 20-year periods (1919-2023).
What this data showed was that the 105 rolling 20-year periods would have produced a positive annualized total return. Simply put, if you had hypothetically purchased an index tracking the S&P 500 at any time since 1900 and held that position for 20 years, you would have made money, without fail, every time.
As scary as the data or short-term forecasts may seem, time and perspective have not let investors down.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Stock Market Crash in 2024? 3 Predictive Indicators That Suggest a Significant Stock Drop was originally published by The Motley Fool
