Jthere’s no denying that Wall Street and investors have been on a meteoric rise since the start of the year. Do you remember that legendary walk to and from school in one meter of snow, uphill, back and forth, that your parents told you about when you were a kid? It is its stock market equivalent.
Since the three major U.S. indices hit all-time closing highs between mid-November and early January, the iconic Dow Jones Industrial Average (DJINDICES: ^DJI)wide seat S&P500 (SNP INDEX: ^GSPC)and technology driven Nasdaq Compound (NASDAQ INDEX: ^IXIC), fell 19%, 24% and 34% respectively as of June 16. More importantly, it puts the Nasdaq and S&P 500 firmly in a bear market. The S&P 500 is often considered the best barometer of the health of the US stock market.
This indicator correctly predicted five S&P 500 bear markets
Although some investors may be surprised that the S&P 500 has lost nearly a quarter of its value in just over five months, a telltale signal with an impeccable track record correctly predicted this fall. This indicator is Shiller’s price-to-earnings (P/E) ratio, also known as the cyclically-adjusted price-to-earnings ratio, or CAPE ratio.
While traditional P/E ratios compare a stock’s price to its earnings over the past 12 months or its projected earnings for the current or coming year, Shiller’s P/E ratio is based on earnings. inflation-adjusted averages for the previous 10 years. .
The telltale bear market warning has come every time the Shiller P/E has breached and held 30. Aside from the fact that the average Shiller P/E since 1870 is just 16.95, pushing at above 30 has a notoriously bad track record:
- 1929: After the Black Tuesday crash, the broader market lost most of its value during the Great Depression. The Dow Jones eventually lost 89% of its value.
- 1997-2001: The S&P Shiller P/E ratio would reach a record level of 44.19 just before the bursting of the dot-com bubble. After the market peak, the S&P 500 lost about half of its value.
- Q3 2018: During the second half of 2018, the Shiller P/E ratio worked its way, briefly, above 30. During the fourth quarter of 2018, the S&P 500 lost 19.8% of its value, or 20 % on a rounded basis. A 20% decline is the accepted threshold for a bear market.
- Q4 2019-Q1 2020: In the six months leading up to the 33-calendar-day coronavirus crash, the S&P Shiller’s P/E ratio was, once again, north of 30. The COVID-19 crash wiped out 34% of the S&P 500.
- Q3 2020-Q2 2022: Finally, the S&P Shiller P/E topped 40 before the S&P 500 rollover in early January 2022. So far, the index is down 24%.
A few caveats to consider
To recap, that’s five instances since 1870 where the Shiller P/E ratio exceeded 30, and five subsequent bear market retracements totaling 20% to 89%. It just has never been wrong.
However, there are a number of caveats that need to be understood before proclaiming this to be the biggest bear market telltale signal of all time.
For example, the “standards” of assessment have changed considerably over the past century. Before the mid-1980s, computers weren’t very common on Wall Street. It took quite a while to spread the news from the businesses on Main Street, which allowed the rumors to perpetuate themselves. In other words, the environment was not conducive to high valuations.
Since the mid-1980s, the information barrier between companies, Wall Street and Main Street, has gradually disappeared. Today, John and Jane Q. Investor can access income statements, balance sheets and management commentary with the click of a button. This easy access to information encourages investors to take on more risk and has therefore inflated Shiller’s P/E ratio over the past 25 years.
Another thing to consider is that while the Shiller P/E ratio has a perfect track record for predicting a potential bear market once valuations extend, there’s no telling how far it will climb above 30, or how much higher. time the Shiller S&P 500 will stay above 30. If you had bet against the benchmark S&P 500 when it first crossed 30 in Q3 2020, you would still be underwater today. today, even with a 24% drop in the index.
Also note that valuation is not always the reason a bear market emerges. The COVID-19 pandemic that cratered the S&P 500 over the five weeks in 2020 has little to do with the perception of extended valuations.
Bear markets are a surefire buying opportunity for the patient
While it may not seem like it right now, bear markets are historically the perfect time to invest.
When looking at the long-term performance of the S&P 500, one thing is very clear, and that is that bull markets last much longer than corrections (i.e. declines of at least 10% from a recent high). Since the start of 1950, the total number of days spent in a bull market has exceeded days spent in a correction by approximately 2.6 to 1. This means that every major correction is an opportunity for patient investors to strike.
If you wonder where to invest, there is no shortage of good ideas.
For example, dividend stocks have a proven track record of outperformance. According to a 2013 report by JP Morgan Asset Management, a division of JPMorgan Chase, income stocks averaged a strong annual return of 9.5% between 1972 and 2012. By comparison, publicly traded stocks that did not pay dividends only earned an average of 1.6% annually. during the same period. Since dividend-paying stocks are almost always profitable and time-tested, they make a good case for increasing their value over time.
Interestingly, growth stocks can be smart investments when the US economy weakens and the S&P 500 enters a bear market. A Bank of America/The Merrill Lynch study published in 2016 found that, over a 90-year period (1926-2015), value stocks outperformed growth stocks in the return column (17% to 12.8%, based on the average annual return). But during periods of weakness, growth stocks have fared considerably better than value stocks.
Investors can also purchase an S&P 500 Tracking Index. According to data from Crestmont Research, if you had hypothetically purchased an S&P 500 Tracking Index and held it for 20 years at any time since 1900, you would have generated a positive total return, including including dividends. There is not a single point on the 20-year rolling timeline of the S&P 500 where this statement is not true.
Patience can pay off on Wall Street.
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Bank of America and JPMorgan Chase are advertising partners of The Ascent, a Motley Fool company. Sean Williams holds positions at Bank of America. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.