It’s been an incredibly volatile start to the decade for Wall Street, with the ageless Dow Jones Industrial Average (DJINDICES: ^DJI)benchmark S&P500 (SNPINDEX: ^GSPC)and driven by growth stocks Nasdaq Composite (NASDAQINDEX: ^IXIC) handling bear and bull markets in consecutive years.
But for the past seventeen months, it has been nothing short of a green light for the bulls. Since the start of 2023, the Dow Jones, S&P 500 and Nasdaq Composite are up 20%, 38% and 60% respectively, with all three indexes rising to record highs. At first glance, it seems like nothing can slow down this red-hot market.
But appearances are deceiving.
Wall Street’s flawless bear market signal is back!
Let me preface this discussion by clearly stating that there is no such thing as a predictive indicator or financial measure that can guarantee, with 100% accuracy, directional movements in the Dow Jones, S&P 500, and Nasdaq Composite. If such a forecasting tool existed, you can be sure that every professional and private investor would use it to gain an edge.
However, there are select indicators and money-based measures that have a long history of closely or perfectly correlating with big moves higher or lower in the stock market. One such indicator, which has an impeccable track record of predicting bear markets (i.e. moves of at least 20% lower in the broad market indexes) is back, providing a stark warning to any investors who will listen.
This telltale forecasting 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 price-to-earnings ratio, which compares a company’s earnings over the past twelve months to its share price. The Shiller P/E ratio is based on average inflation-adjusted earnings over the past ten years. Leveraging a decade of earnings history softens the impact of one-off events such as the COVID-19 pandemic, giving investors a clearer view of valuation trends.
As of the closing bell on May 16 – a day when the Dow Jones Industrial Average briefly touched 40,000 on an intra-day basis for the first time – the Shiller price-to-earnings ratio of the S&P 500 closed at 34.66. This is more than double the average value of 17.12 for the Shiller price-to-earnings ratio when backtested to 1871.
But it’s not a concern how far Shiller’s price-to-earnings ratio is above the historical average. Rather, it’s what has happened for the past 153 years whenever the Shiller P/E crosses 30 (and stays above this level) during a bull market rally.
Since 1871, there have only been six instances of the Shiller P/E rising above 30 during a bull market – and the previous five instances all resulted in the major stock indexes possibly tumble:
-
August 1929-Sept. 1929: The Shiller P/E first reached the 30 mark just before the Great Depression took shape. The Dow Jones ultimately lost 89% of its value in the following years.
-
June 1997-August. 2001: The all-time high for the Shiller P/E (44.19) occurred before the dot-com bubble burst in December 1999. When the dot-com bubble burst, the S&P 500 lost about half its value, while the Nasdaq Composite fell. hit even harder.
-
September 2017-Nov. 2018: The Shiller price-to-earnings ratio was above 30 again for over a year between 2017 and 2018, leading to a 20% decline in the S&P 500 in the fourth quarter of 2018.
-
December 2019-February 2020: The Shiller P/E rose rapidly just before the COVID-19 pandemic. The COVID crash has 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 experienced bear market declines, with the Nasdaq losing 33% in 2022.
-
November 2023-current: As noted, the Shiller P/E is approaching 35, which is the third highest value during an individual bull market run.
The caveat to the above is that the Shiller P/E does not help in estimating when a decline in the Dow Jones, S&P 500 and Nasdaq Composite might occur. For example, the COVID-19 crash was a complete surprise, while valuations remained high for more than four years during the dot-com bubble before bouncing back.
But what the Shiller P/E clearly shows is that high valuations cannot be sustained in the long term. While 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’ve seen since the mid-1990s, a Shiller P/E of almost 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 optimistic side
Considering how powerful the bull market rally has been for more than a year, a cautionary tale about a potential bear market is probably not what investors want to hear. But it’s important to have these discussions to recognize that history largely belongs to optimistic investors with a long-term mindset.
To put it bluntly, economic recessions, stock market corrections, and even bear markets are normal and inevitable events. As much as we hate the idea of a sea of red temporarily swallowing our stock portfolios, or of wage growth slowing during an economic contraction, all the wishes in the world won’t keep these events from happening every now and then occur.
But this is where history comes in handy. Although there have been twelve U.S. recessions since the end of World War II in September 1945, only three of these recessions lasted one year. Of the remaining three, none exceeded 18 months.
On the other side of this historical coin, most growth periods have lasted several years, including two economic expansions that lasted longer than a decade. Most publicly traded companies in the Dow Jones, S&P 500 and Nasdaq Composite can benefit from long-winded expansions.
This two-sided and disproportionate coin that we call history also applies on Wall Street.
In June 2023, researchers at Bespoke Investment Group released a data set that examined every bear and bull market in the S&P 500, going back to the start of the Great Depression in September 1929. As you can see in the post above from Bespoke on social media media platform X there were 27 separate bear and bull markets.
Remarkably, the average duration of S&P 500 bull markets (1,011 calendar days) is about 3.5 times longer than the typical S&P 500 bear market (286 calendar days) over a 94-year period. Furthermore, thirteen bull markets have lasted longer than the longest bear market since the Great Depression. It definitely pays to be a Wall Street optimist.
But it is also important to look at the horizon. A study by economic research firm Crestmont Research analyzed the 20-year rolling total returns, including dividends paid, of the S&P 500 since the early 20th century. Although the S&P didn’t come into existence until 1923, researchers were able to backtest 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 twenty-year periods it examined (1919-2023) produced positive total returns. In plainer English: If, hypothetically, you had purchased an S&P 500 tracking index at each point since 1900 and held for twenty years, you made money. No matter what doom and gloom forecasts hit Wall Street, the S&P 500 has always been higher on a total return basis twenty years later.
Even if history were to repeat itself and valuations were to contract sharply in the not-too-distant future, patient investors would likely benefit from the short-term discounts they would receive on high-quality stocks.
Where you can invest $1,000 now
When oour analyst team has a stock tip, it can pay to listen. The newsletter they have been publishing for more than ten years, Motley Fool stock advisorhas almost tripled the market.*
They just revealed what they believe to be the 10 best stocks for investors to buy now…
View the 10 stocks
*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 stocks mentioned. The Motley Fool has a disclosure policy.
Wall Street’s telltale bear market warning is back with a vengeance was originally published by The Motley Fool
