In case you haven’t noticed, the bulls are in control on Wall Street. Since 2024, the iconic started Dow Jones Industrial Average(DJINDICES: ^DJI)widely supported S&P500(SNPINDEX: ^GSPC)and innovation-driven Nasdaq Composite(NASDAQINDEX: ^IXIC) are up 17%, 26% and 28% respectively (as of the closing bell on November 13) and have risen to multiple all-time highs.
A number of factors are responsible for pushing Wall Street’s major stock indexes to new highs, including excitement about the artificial intelligence (AI) revolution, euphoria about the stock split and optimism about President-elect Donald Trump’s second term in the Oval Office.
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But when things on Wall Street seem too good to be true, they usually are.
Image source: Getty Images.
Throughout the year, there have been a number of correlative events, forecast tools and data points that have warned of potential weakness in the US economy and/or stock market. This includes the first notable decline in the US M2 money supply since the Great Depression, the longest yield curve inversion in history, and the related performance of stocks as the Federal Reserve shifts into a rate easing cycle.
However, there is one historically impeccable valuation metric that stands head and shoulders above these other instruments, and it is currently doing something that has only been observed three times in more than 150 years.
Most investors are probably familiar with or rely on the traditional price-to-earnings (P/E) ratio, which divides a company’s share price into its trailing twelve-month earnings per share (EPS). The price-to-earnings ratio provides a relatively quick way to compare a company’s valuation with its peers or the broader market.
However, the traditional price-earnings ratio also has limitations. Specifically, it doesn’t work particularly well with growth stocks because it doesn’t take into account future growth rates, and can easily be disrupted by shocking events, such as the lockdowns that occurred during the early stages of the COVID-19 pandemic.
A much more comprehensive valuation tool, and the metric currently making history, is the S&P 500’s Shiller P/E ratio, also called the cyclically adjusted P/E ratio or CAPE ratio. The Shiller P/E takes into account the average inflation-adjusted earnings per share over the past ten years, softening the impact of shock events and allowing apples-to-apples valuation comparisons over more than 150 years.
S&P 500 Shiller CAPE Ratio data according to YCharts.
As of the closing bell on November 13, the S&P 500’s Shiller P/E clocked in at 38.18, more than double the average reading of 17.17 when backtested to January 1871.
But more importantly, Shiller’s price-to-earnings ratio has reached 38 only three times in 153 years. In December 1999, during the dot-com boom, the Shiller price-to-earnings ratio peaked at 44.19. Meanwhile, it briefly rose above 40 in the first week of 2022.
What’s remarkable is what happened to Wall Street’s major stock indexes after these previous periods, when valuations became very clearly overextended. The dot-com bubble resulted in a 49% peak-to-trough decline in the S&P 500 and a significantly steeper decline in the Nasdaq Composite. Meanwhile, the Dow Jones, S&P 500, and Nasdaq Composite will enter bear markets in 2022, respectively.
Going back even further, there have only been six instances of the Shiller P/E exceeding 30 since 1871, including the present. After each of the five previous events, the Dow Jones, S&P 500 and/or Nasdaq Composite ultimately fell between 20% and 89%.
While the Shiller P/E doesn’t tell us anything about when stock market corrections/bear markets might occur, it has an impeccable track record so far at predicting big moves lower in the stock market.
Image source: Getty Images.
Based on what history tells us, at some point in the not-too-distant future we will see a pretty significant drop in the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite. But if you’re a long-term investor looking to the horizon, history also has a message for you: perspective changes everything.
In the shorter term, it can be difficult, if not downright impossible, to predict what the US economy or stock market will do. For example, recessions are a normal and inevitable part of the economic cycle. No matter how many times we cross our fingers and think good thoughts, economic contractions will eventually occur.
But the thing about recessions is that they are short-lived. If you step back and look at the bigger picture, you’ll see that nine of the twelve post-World War II recessions were resolved in less than a year, while the remaining three failed to exceed eighteen months.
At the other end of the spectrum, two economic expansions have reached the ten-year mark since the end of World War II. The point is that the US economy spends significantly more time in the sun than it does navigating a storm – but you have to take a step back to see this dynamic play.
The same goes for Wall Street.
The dataset you see above was posted on social media platform X in June 2023 by the researchers at Bespoke Investment Group. It shows the calendar day length of every bear and bull market in the benchmark S&P 500, dating back to the start of the Great Depression in September 1929.
As you can see from the table, the average bear market decline in the S&P 500 is only 286 calendar days, or about 9.5 months. This is consistent with the downturn in the US economy passing quickly.
On the other hand, the average bull market in the S&P 500 over a 94-year period has lasted 1,011 calendar days, which is about two years and nine months. Including the current bull market rally, just over half (14 out of 27) of all bull markets for the S&P 500 have lasted longer than the longest bear market.
While a stock market downturn is normal and inevitable, the perspective shows how powerful patience can be for long-term investors.
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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.
The Stock Market Does Something We’ve Witnessed Only Three Times in 153 Years — and History Is Very Clear What Happens Next was originally published by The Motley Fool
