Over longer periods of time, the stock market outperforms all other asset classes. Over the past century, the average annual return of Wall Street's major stock indexes was – the Dow Jones Industrial Average (^DJI -0.37%), S&P 500 (^GSPC -0.48%), and Nasdaq Composite (^IXIC -0.82%) – has significantly outperformed the annualized returns of oil, gold, certificates of deposit (CDs) and Treasury bonds over the same period.
But it's a whole different story when you narrow the lens. Since the beginning of this decade, the Dow Jones, S&P 500 and Nasdaq Composite have experienced alternating bear and bull markets in consecutive years. After record highs for the Dow and S&P 500 and a nearly 60% rise for the Nasdaq Composite from its bear market low in 2022, this pattern suggests Wall Street could be in for a difficult 2024.
Image source: Getty Images.
Even though short-term directional movements in major Wall Street indices cannot be predicted with 100% accuracy, that doesn't stop investors from getting a head start. In particular, a valuation tool that has a track record of more than 150 years could provide an answer to what happens next for stocks.
Are the Dow, S&P 500 and Nasdaq Composite heading for a crash?
While “value” is a subjective term that depends entirely on the growth rate and risk tolerance of individual investors, the valuation metric that has historically had an uncanny ability to predict directional moves in the stock market is the S&P 500's Shiller price-to-earnings ratio (The P/E ratio 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 examines a company's stock price relative to its trailing 12-month earnings. The P/E ratio is the most popular and fundamental measure of value on Wall Street.
However, the traditional P/E ratio can be distorted due to unforeseen events. For example, the COVID-19 pandemic hurt corporate profits in 2020, while fiscal stimulus artificially boosted profits in 2021.
The difference with the Shiller P/E ratio is that it is based on average inflation-adjusted earnings over the last ten years. Using a decade's worth of earnings history smooths out the spikes and dips associated with unforeseen events and provides a more complete valuation picture for Wall Street's benchmark index, the S&P 500.
Although the Shiller P/E ratio only came to prominence in the late 1990s, it has been tested back to 1871. Over this 150+ year period, the average Shiller P/E for the S&P 500 is 17.09. But as you can see from the chart below, the value has been above this mark for almost all of the last 30 years.
S&P 500 Shiller CAPE Ratio data from YCharts.
Investors' willingness to accept continued higher valuations appears to be driven by the Internet democratizing access to information and falling interest rates. Lower interest rates encourage companies to borrow, which can spur hiring, acquisitions and innovation.
What's particularly notable about the Shiller P/E ratio, however, is what has happened throughout history every time it crosses the 30 mark during a bull market rally. Looking back over more than 150 years, there have only been six instances where this level has been proven to be exceeded and maintained – and in all previous events, this indicated a significant downward move in the overall market:
- Aug. 1929 – Sept. 1929 1929: The Shiller P/E ratio exceeded 30 as the Great Depression took shape, ultimately pushing the Dow Jones Industrial Average down to a high of 89%.
- June 1997 – August 2001: The Shiller P/E reached its all-time high of 44.19 during the dot-com bubble. The benchmark S&P 500 lost around half of its value at its low point.
- Sept. 2017-Nov. 2018: After the S&P 500 topped 30 again, a sell-off in the fourth quarter of 2018 cost it 20% of its value.
- Dec. 2019-Feb. 2020: Just before the COVID-19 crash, the Shiller P/E jumped above 30. In less than five weeks, the S&P 500 plunged 34%.
- August 2020 – May 2022: After briefly hitting 40 in 2022, the bear market fell as much as 28% off the S&P 500 at its peak.
- Nov. 2023 – current: At the closing bell on February 15, 2024, the Shiller P/E ratio was 33.85.
In other words, the S&P 500's Shiller P/E ratio has an impeccable track record of predicting at least a 20% decline in the broad-based index when it exceeds 30.
The disadvantage of the Shiller P/E ratio is that it is not a timing tool. Just because the Dow Jones, S&P 500, and Nasdaq Composite are historically expensive doesn't mean these indices can't remain expensive for months or years. You'll notice that the Shiller P/E ratio was above 30 for more than four years before the dot-com bubble burst.
Nonetheless, the message seems clear that a significant decline in stock prices is imminent at some point in the future.
Image source: Getty Images.
Stock market corrections and bear markets can be blessings in disguise
To be fair, the Shiller P/E ratio is just one of about half a dozen predictive indicators and data points I've recently examined that point to either a U.S. recession or a correction/bear market for stocks in the stock market. While this may not be the news investors want to hear, corrections and bear markets are known to be blessings in disguise.
As much as we may dislike recessions, they are a normal part of the economic cycle. The thing about recessions is that they are short-lived. Nine of the 12 U.S. recessions since the end of World War II have subsided in less than a year. In comparison, two expansion periods reached the 10-year mark in the same period.
This observed discrepancy between the duration of recessions and periods of economic growth can also be observed on Wall Street.
To be clear, we will never know exactly when stock market corrections or bear markets will begin, how long they will last, or how much the major stock indices will ultimately fall. However, history tells us that every double-digit percentage decline in the Dow Jones, S&P 500 and Nasdaq Composite was ultimately offset by a bull market. In other words, patience and foresight are incredibly powerful tools for investors.
History also shows that bull markets tend to significantly outlast bear markets.
It is official. A new bull market is confirmed.
The S&P 500 is up 20% from its closing low on 10/12/22. The previous bear market caused the index to fall by 25.4% in 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
– Bespoke (@bespokeinvest) June 8, 2023
Last June, researchers at Bespoke Investment Group released a data set that compared the length of every bear market in the S&P 500 since the start of the Great Depression in September 1929 with every S&P 500 bull market during the same period. While the average bear market only lasted 286 calendar days, the typical bull market lasted 1,011 calendar days.
Additionally, 13 of the 27 S&P 500 bull markets over the past 94 years 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 continues its 150-plus-year impeccable trend and predicts a decline of at least 20% in the S&P 500, long-term investors can have confidence that stocks will eventually recover. That makes any significant downturn in the stock market a boon for patient investors who have cash to put to work.