The start of the decade was incredibly volatile for Wall Street, with the market ageless Dow Jones Industrial Average (DJ CLUES: ^ DJI)reference S&P500 (INDEXSNP: ^GSPC)and powered by growth stocks Nasdaq Composite (NASDAQ INDEX: ^IXIC) trading bear and bull markets in successive years.
But it makes nothing less than a green light for the bulls in the last 17 months. Since the start of 2023, the Dow Jones, S&P 500 and Nasdaq Composite have gained 20%, 38% and 60%, respectively, with all three indexes reaching record highs. On the surface, it seems like nothing can slow down this hot market.
But appearances can be deceiving.
Wall Street’s impeccable bear market signal is back!
Let me begin this discussion by clearly stating that there is no predictive indicator or financial measure that can, with 100% accuracy, guarantee the directional movements of the Dow Jones, S&P 500, and Nasdaq Composite . If such a forecasting tool existed, you can rest assured that all professional and retail investors would use it to gain an edge.
There are, however, certain monetary indicators and measures that have long been closely or perfectly correlated with major upward or downward movements in the stock market. One of these indicators, which has proven itself in terms of forecasting bear markets — that is, declines of at least 20% in general market indexes — is back and sending a clear warning to all investors who will listen.
This revealing prediction tool is none other than the Shiller price-to-earnings (P/E) ratio of the S&P 500, also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio.
Most investors are probably familiar with the traditional P/E ratio, which looks at a company’s earnings over the past 12 months relative to its stock price. The Shiller P/E ratio is based on inflation-adjusted average earnings over the previous 10 years. Using a decade-long earnings history mitigates the impact of one-off events, such as the COVID-19 pandemic, to allow investors to have a clearer idea of ​​valuation trends.
As of the closing bell on May 16 – the day on which the Dow Jones Industrial Average briefly eclipsed 40,000 for the first time on an intraday basis – the Shiller P/E ratio of the S&P 500 closed at 34.66. That’s more than double the Shiller P/E average of 17.12 when back-tested through 1871.
But it’s not the extent to which Shiller’s P/E ratio is higher than its historical average that’s concerning. Rather, this is what has happened over the past 153 years every time the Shiller P/E rises above 30 (and stays above that level) during a bull market rally.
Since 1871, there have only been six instances where the Shiller P/E has exceeded 30 during a bull market – and the previous five instances have all resulted in the major stock indexes. Ultimately tumble:
August 1929-Sept. 1929: The Shiller P/E first rose above 30 just before the Great Depression took shape. The Dow ultimately lost 89% of its value over the next few years.
June 1997-August. 2001: The highest reading ever recorded for the Shiller P/E (44.19) occurred before the dot-com bubble burst in December 1999. Once the dot-com bubble burst, the S&P 500 lost about half of its value, while the Nasdaq Composite was falling. hit even harder.
September 2017-Nov. 2018: The Shiller P/E again exceeded 30 for more than a year between 2017 and 2018, leading to a 20% decline in the S&P 500 during the fourth quarter of 2018.
Dec. 2019-Feb. 2020: Shiller P/E was climbing rapidly just before the COVID-19 pandemic. The COVID crash wiped out 34% of the S&P 500 in 33 calendar days.
August 2020-May 2022: During the first week of January 2022, the Shiller P/E peaked at just over 40. After this peak, all three stock indexes suffered bear market declines, with the Nasdaq losing 33% in 2022.
November 2023-current: As noted, the Shiller P/E is near 35, which is its third highest reading during an individual bull market.
The caveat to the above is that the Shiller P/E offers no help in gauging when declines in the Dow, S&P 500, and Nasdaq Composite might occur. For example, the COVID-19 crash was a complete surprise, while valuations during the dotcom bubble remained high for more than four years before falling again.
But what Shiller’s P/E clearly shows is that high valuations cannot be sustained over the long term. Although the advent of the Internet and historically low interest rates have increased investors’ willingness to take risks, which partly explains the rise in the Shiller P/E we have seen since the mid-1990s , a Shiller P/E of nearly 35 is a pretty telling bear market warning for Wall Street and investors.
History is a two-sided and disproportionate coin that favors the patient and the optimists.
Given how strong the bull market has been rallying for over a year, investors probably don’t want to hear a warning about a potential bear market. But it’s important to have these discussions to recognize that history is largely on the side of optimistic investors with a long-term mindset.
To be perfectly blunt, economic recessions, stock market corrections and even bear markets are normal and inevitable events. Even if we don’t like the idea of ​​a sea of ​​red temporarily engulfing our stock portfolios or slowing wage growth during an economic contraction, all the wishing in the world won’t prevent these events. to materialize from time to time.
But this is where the story comes in handy. Although there have been 12 recessions in the United States since the end of World War II in September 1945, only three of them lasted a year. Of the other three, none lasted more than 18 months.
On the other side of this historical coin, most growth periods lasted several years, including two economic expansions that lasted more than 10 years. Most public companies in the Dow, S&P 500 and Nasdaq Composite are positioned to benefit from long-term expansions.
This two-sided, disproportionate coin we call history also applies to Wall Street.
In June 2023, researchers at Bespoke Investment Group released a dataset examining every S&P 500 bear and bull market dating back to the start of the Great Depression in September 1929. As you can see in Bespoke’s post above on social networks. On the X media platform, there have been 27 distinct bear and bull markets.
It should be noted that the average duration of S&P 500 bull markets (1,011 calendar days) is approximately 3.5 times longer than that of the typical S&P 500 bear market (286 calendar days) over a 94-year period. Additionally, 13 bull markets have lasted longer than the longest bear market since the Great Depression. It absolutely pays to be optimistic on Wall Street.
But it is also essential to look towards the horizon. A study by economic research firm Crestmont Research analyzed rolling 20-year total returns, including dividends paid, of the S&P 500 since the start of the 20th century. Even though the S&P didn’t come into existence until 1923, researchers were able to back-test it back to 1900 by tracing the returns of its components in other major indexes before its creation.
What Crestmont Research found was that all 105 rolling 20-year periods examined (1919-2023) produced positive total returns. In simpler terms, if you had, hypothetically, purchased an S&P 500 tracking index at any of them point since 1900 and held for 20 years, you made money. Regardless of the pessimistic forecasts weighing on Wall Street, the S&P 500 has still been higher in terms of total return 20 years later.
Even if history were to repeat itself and valuations contract significantly in the not-so-distant future, patient investors would likely benefit from the short-term discounts they receive on high-quality stocks.
Where to invest $1,000 now
When oyour team of analysts has a stock tip, it might pay to listen. After all, the newsletter they have been running for over a decade, Motley Fool Stock Advisoralmost tripled the market.*
They just revealed what they think is the 10 best stocks for investors to buy now…
*Stock Advisor returns May 13, 2024
Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the securities mentioned. The Mad Motley has a disclosure policy.
Wall Street’s telltale warning of a bear market is back with a vengeance was originally published by The Motley Fool
