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When examined over long periods of time, the stock market dwarfs all other asset classes. Over the past century, the average annual return of Wall Street’s major stock indexes has been Dow Jones Industrial Average (^DJI -0.37%), S&P500 (^GSPC -0.48%)and Nasdaq Composite (^IXIC -0.82%) –Widely exceeds the annualized returns of oil, gold, certificates of deposit (CDs), and U.S. Treasuries over the same timeline.
However, when you stop down the lens, the story changes dramatically. Since the beginning of this decade, the Dow Jones, S&P 500, and Nasdaq Composite have alternated between bear markets and bull markets every year. With the Dow and S&P 500 at record highs, and the Nasdaq Composite up nearly 60% from its 2022 bear market lows, this pattern signals that Wall Street could be in for a tough 2024. Suggests.
Image source: Getty Images.
It’s impossible to predict the short-term directional movements of Wall Street’s major indexes with 100% accuracy, but that doesn’t stop investors from trying to get an edge. One valuation tool in particular, with a flawless track record dating back more than 150 years, may provide answers about the future of stocks.
Are the Dow, S&P 500, and Nasdaq Composite on the brink of collapse?
While “value” is a subjective term that depends entirely on growth rates and an individual investor’s risk tolerance, the valuation metric that has historically had an uncanny ability to predict stock market direction is the S&P 500 Shiller price-to-earnings (P/E) ratio. This is also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio.
Most investors are familiar with the traditional P/E ratio, which looks at a company’s stock price compared to its earnings over the past 12 months. The P/E ratio is the most common and fundamental measure of value on Wall Street.
However, traditional P/E ratios can be distorted by unforeseen events. For example, in 2020, the COVID-19 pandemic devastated corporate profits, but in 2021, fiscal spending artificially boosted profits.
What makes the Shiller P/E different is that it is based on average inflation-adjusted earnings over the past 10 years. Using 10 years of earnings history smoothes out the spikes and dips associated with unexpected events and provides a more complete valuation picture for Wall Street’s benchmark index, the S&P 500.
The Shiller PER did not become popular until the late 1990s, but it has been backtested as far back as 1871. The average Shiller P/E for the S&P 500 over this 150-year period is 17.09. However, as you can see in the graph below, it has stayed above this mark for almost all of the past 30 years.
S&P 500 Shiller CAPE Ratio data by YCharts.
Investors’ willingness to accept persistently high valuations appears to be a result of the democratization of access to information via the Internet and lower interest rates. Lower interest rates could encourage businesses to borrow, which could spur hiring, acquisitions, and innovation.
But what’s particularly interesting about the Shiller P/E is what has happened throughout history every time the Shiller P/E exceeded 30 during a bull market rally. Looking back over 150 years, he has only held clearly above this level six times, and in all previous events it has been a harbinger of a major decline in the broader market. .
- August-September 1929 1929: As the Great Depression took hold, the Shiller P/E rose above 30, ultimately pushing the Dow Jones Industrial Average down by 89% from its peak.
- June 1997-August 2001: Shiller P/E reached a high of 44.19 during the dot-com bubble. The benchmark S&P 500 lost about half its value at the bottom.
- September 2017 – November 2018: After rising above 30 again, the S&P 500 lost 20% of its value due to the sharp decline in the fourth quarter of 2018.
- December 2019 – February 2020: Just before the crash due to the coronavirus pandemic, the Shiller P/E ratio was over 30 times. In less than five weeks, the S&P 500 fell 34%.
- August 2020 – May 2022: The 2022 bear market briefly reached 40 before falling 28% from its peak in the S&P 500 index.
- November 2023 to present:As of the closing price on February 15, 2024, Shiller P/E was 33.85.
In other words, the S&P 500’s Shiller P/E has a perfect track record of predicting at least a 20% decline in the broad index when it exceeds 30.
The disadvantages of Shiller PER are: do not have timing tool. Just because the Dow Jones, S&P 500, and Nasdaq Composite are historically expensive doesn’t mean these indexes can’t remain expensive for months or years. You can see that before the dot-com bubble burst, Shiller’s P/E ratio had been below 30 for over four years.
Nevertheless, there do seem to be statements that suggest a significant drop in stock prices is in store at some point in the future.
Image source: Getty Images.
Stock market corrections and bear markets could be a hidden blessing
To be fair, the Shiller P/E is only one of about half a dozen predictive indicators and data points I’ve looked at recently that indicate either a U.S. recession or a stock market correction/bear market. This may not be the news investors want to hear, but corrections and bear markets are known to be a blessing in disguise.
We may hate recessions, but they are a normal part of the economic cycle. The characteristic of economic recessions is that they don’t last long. Nine of the 12 recessions that occurred in the United States after World War II were resolved within a year. By comparison, two expansion periods reached his decade mark in the same period.
This observed difference between the length of recessions and periods of economic growth is also visible on Wall Street.
Frankly, we can never know exactly when a stock market correction or bear market will begin, how long it will last, or how much major stock indexes will ultimately fall. But history tells us that double-digit declines in the Dow Jones, S&P 500, and Nasdaq Composite were all eventually canceled out by a bull market. In other words, patience and perspective are very powerful tools for investors.
History also shows that bull markets tend to outlast bear markets more easily.
It’s official. A new bull market has been confirmed.
The S&P 500 is currently up 20% from its October 12, 2022 closing low. During the last bear market, the index fell 25.4% in 282 days.
For more information, please visit https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
— Bespoke (@bespokeinvest) June 8, 2023
Last June, Bespoke Investment Group researchers compared the length of every S&P 500 bear market since the beginning of the Great Depression in September 1929 to the length of every S&P 500 bull market over the same period. The compared data sets were presented. The average bear market lasted only 286 calendar days, while the typical bull market lasted 1,011 calendar days.
Additionally, 13 of the 27 S&P 500 bull markets over the past 94 years have lasted longer than the longest bear market. From a mathematical perspective, betting on the future success of American companies has always been a money-making strategy.
Even though the Shiller P/E ratio has maintained a perfect record of predicting at least a 20% decline in the S&P 500 over more than 150 years, long-term investors can be confident that stocks will eventually recover. So for patient investors who have money to invest, any significant decline in the stock market is a blessing in disguise.
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