In October, Wall Street celebrated the two-year anniversary of the current bull market. The mature equity drive started this year Dow Jones Industrial Average(DJINDICES: ^DJI)benchmark S&P500(SNPINDEX: ^GSPC)and driven by growth stocks Nasdaq Composite(NASDAQINDEX: ^IXIC) have risen 19%, 28% and 31% respectively since the closing bell on December 4. They have also achieved multiple all-time highest closing marks.
There is no single catalyst behind this outperformance, but rather a combination of factors that are lifting Wall Street’s sails. In no particular order, these catalysts include:
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The rise of artificial intelligence (AI), which, according to PwC, is in Determine the pricecould increase global gross domestic product by $15.7 trillion by 2030.
Stock split euphoria, with more than a dozen leading companies announcing or completing stock splits in 2024.
The victory of newly-elected President Donald Trump in November, leading Wall Street to anticipate a lower corporate tax rate and heavy share buybacks from America’s most influential companies.
While things seemingly couldn’t be better for Wall Street, history would like to have a word.
Image source: Getty Images.
For over a year now, there have been a number of forecasting tools and predictive numbers pointing to trouble for Wall Street and/or the US economy. Examples of this include the first significant decline in the US M2 money supply since the Great Depression, and the longest yield curve inversion in history, which has historically been a key ingredient for a US recession.
But the indicator that most portends disaster for Wall Street may be the S&P 500’s Shiller price-to-earnings (P/E) ratio, also known as the cyclically adjusted P/E ratio or CAPE ratio. named.
Whether you’ve been investing for decades or just a few weeks, you’re probably familiar with the traditional price-to-earnings (P/E) ratio, which divides a company’s share price into its trailing-twelve-month earnings per share (EPS). This valuation tool provides investors with a quick and concise way to determine whether a stock is cheap or pricey, respectively, compared to its peers and the broader market.
Although the price-earnings ratio has been around for centuries, it also has its limitations. For example, it doesn’t take into account a company’s growth potential, nor does it do particularly well during shocking events. The traditional price-to-earnings ratio was quite useless during the early stages of the COVID-19 pandemic, when most publicly traded companies were negatively impacted by a historic demand cliff.
On the other hand, the S&P 500’s Shiller P/E is based on average inflation-adjusted earnings over the past ten years. Because it covers a decade of earnings history, it can minimize the impact of shock events, allowing for more accurate valuation comparisons going back to the early 1870s.
S&P 500 Shiller CAPE Ratio data according to YCharts.
When the closing bell rang on December 4 (and the S&P 500 closed at a new record high), the S&P 500’s Shiller P/E clocked in at 38.87. This is the highest value during the current bull market rally and is more than double the 17.17 average for the Shiller P/E, retested to January 1871.
Perhaps more importantly, this is only the third time in 153 years that the S&P 500’s Shiller price-to-earnings ratio has approached or exceeded 39. In the first week of January 2022, the price briefly passed 40, after which a bear market followed. In 2022, the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all lost more than 20% of their value on a peak-to-trough basis.
The only other time since 1871 that Shiller’s price-to-earnings ratio was even higher occurred before the dot-com bubble burst in December 1999, where it peaked at 44.19. When the dot-com bubble finally burst, the S&P 500 lost 49% and the Nasdaq Composite plunged 78% before bottoming out.
Testing back to 1871, there are only six occurrences, including the current one, where the S&P 500’s Shiller P/E reached 30 during a bull market rally. All five previous cases were ultimately followed by declines of 20% to 89% in one or more of Wall Street’s major stock indexes.
While the Shiller P/E is not a timing tool—stock valuations can remain extended for weeks, months, or even years—it has flawlessly foreshadowed a major drop in stock prices for more than a century (when back-tested).
Image source: Getty Images.
Admittedly, these aren’t the rosiest predictions for Wall Street, and it’s probably not what investors want to hear. But the interesting thing about history is that it is a two-sided coin – and those sides are not necessarily the same.
For example, neither working Americans nor investors look forward to recessions. The unemployment rate rises, wage growth slows or reverses, and stocks often perform poorly when the U.S. economy turns south. No amount of good wishes can stop these normal and inevitable downturns in the economic cycle.
But at the same time, recessions are historically short-lived. Since the end of World War II in September 1945, there have been twelve U.S. recessions, nine of which resolved in less than a year. Of the remaining three, none lasted longer than 18 months.
By comparison, most of the economic expansions since the end of World War II have lasted several years, including two periods of growth that lasted at least a decade. Although recessions and expansions are both part of the economic cycle, the economy spends a disproportionate amount of time growing, which is why corporate profits tend to rise in the long run.
This same pendulum also creates a favorable difference between bear and bull markets on Wall Street.
The dataset you see above was posted by Bespoke Investment Group on social media platform X in June 2023. Although somewhat dated, this data set illustrates the importance of time and perspective when investing on Wall Street.
Bespoke calculated the calendar day length of every bear and bull market in the broad-based S&P 500 since the start of the Great Depression in September 1929. In total, this amounted to 27 separate bear and bull markets.
While the average bear market over a 94-year period has lasted only 286 calendar days (about 9.5 months), the typical S&P 500 bull market lasted 3.5 times as long (1,011 calendar days). It’s also worth pointing out that more than half of all bull markets (14 out of 27, including the current bull market) have lasted longer than the longest bear market, which lasted 630 calendar days.
With time and the right perspective, even the bleakest short-term forecasts can prove beneficial for long-term investors.
Consider the following before purchasing shares in the S&P 500 Index:
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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 that has only been seen three times since 1871 – and the history is crystal clear What happens next was originally published by The Motley Fool
