For patient investors, Wall Street’s four-year (and counting) bull market has been rewarding. Since the 2022 bear market bottomed out, the timeless Dow Jones Industrial Average (DJ INDICES: ^ DJI), reference S&P500 (SNPINDEX: ^GSPC) and focused on innovation Nasdaq Composite (NASDAQINDEX:^IXIC) have all reached all-time highs.
Several factors fueled the wind in the sails of the stock market, including:
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The development of artificial intelligence (AI) infrastructure
Corporate profits better than expected
The arrival and early adoption of quantum computing
Euphoria around record IPOs
Record share buybacks by S&P 500 companies
Although history clearly shows that the Dow, S&P 500, and Nasdaq Composite rise over long periods of time, it also tells us that bull markets are not indefinite. For seemingly every catalyst, there are headwinds waiting to disrupt the AI-driven stock market rally.
Image source: Getty Images.
We are currently seeing the stock market do something for only the fifth time in the last 30 years – and history has made it clear that when this signal appears, a significant a change in direction of actions soon follows.
This has only been observed five times since late 1996.
While there are plenty of equity market headwinds, such as the parabolic rise in outstanding margin debt and the rapid rise in long-duration Treasury yields, arguably no downward catalyst is more telling than premium equity valuations.
“Value” is one of the most difficult topics to discuss on Wall Street, primarily because there is no single method for evaluating and valuing each individual company and the market as a whole. The valuation process introduces subjectivity and emotion, making it virtually impossible to accurately predict the short-term directional movements of individual stocks and major Wall Street stock indexes.
While no indicator can ever guarantee what will happen, some past events can be great educational tools for investors willing to listen. One such indicator, with an impeccable track record of foreshadowing short-term directional moves in the Dow, S&P 500, and Nasdaq Composite, is the Shiller price-to-earnings (P/E) ratio of the S&P 500, also known as the cyclically adjusted P/E ratio (CAPE ratio).
The Shiller P/E ratio is based on inflation-adjusted average earnings over the past 10 years, meaning that recessions, which can turn company earnings negative over a short period of time, will not minimize the usefulness of this valuation tool.
When backtested over the past 156 years, the Shiller P/E ratio of the S&P 500 averaged 17.44. On October 30, this proven valuation tool closed at a multiple of 40.13, or 130% above its long-term average.
Over the past 30 years, the Shiller P/E has exceeded 30 on five occasions, including today, and the stock market has seen a significant drop after each of the previous four instances:
June 1997 to August 2001: During the Internet frenzy of the mid-to-late 1990s, investors demonstrated a willingness to pay high premiums (the CAPE ratio reached its all-time high of 44.19 in December 1999) and take big risks on high-growth Internet stocks. After the dot-com bubble burst in March 2000, the S&P 500 and the Nasdaq Composite lost 49% and 78% before returning to their respective lows.
September 2017 to November 2018: The CAPE ratio rose above 30 again as the hype around blockchain technology took shape. During the fourth quarter of 2018, Wall Street’s benchmark index lost approximately 20% of its value.
December 2019 to February 2020: Before the COVID-19 crash of February-March 2020, the Shiller P/E still exceeded 30. The COVID-19 crash erased 34% of the value of the S&P 500 in just 33 calendar days.
August 2020 to May 2022: Investors’ willingness to take risks and pay substantial valuation premiums returned as the U.S. government rolled out several rounds of fiscal stimulus during the pandemic. The CAPE ratio peaked just above 40 in January 2022. However, the nine-month bear market in 2022 fell approximately 20%, 25%, and 33% against the Dow, S&P 500, and Nasdaq, respectively.
November 2023 to present: The AI revolution has made it the second most expensive stock market in history, with the CAPE ratio peaking at 42.84 in early June.
To be clear, the Shiller P//E ratio of the S&P 500 cannot tell us when stocks will peak or what catalysts will push the market as a whole over the edge. What this shows is that premium valuations have historically foreshadowed significant decline in the stock market.
Image source: Getty Images.
History is a two-way street
If the story were to rhyme, which is quite common on Wall Street, one would expect a decline of 20% or more in one or more of Wall Street’s major stock indexes. Given that it is the second most expensive stock market, history suggests that a pullback of more than 35% to bring Shiller’s P/E below 30 could be justified.
While this isn’t the most optimistic forecast for investors, it’s worth noting that history is a two-way street – and it tends to favor the optimists far more than the pessimists.
On the one hand, bear market declines are akin to the price of entry to invest in one of the greatest wealth creators on the planet. On the other hand, recessions share a common theme: they are short-lived.
^SPX data by YCharts.
In late May, Bespoke Investment Group calculated the duration of each S&P 500 bull and bear market since the start of the Great Depression in September 1929. This yielded 54 events, with 27 distinct bull and bear markets.
While the average S&P 500 bear market lasted only 286 calendar days, the typical bull market lasted nearly 3.6 times longer (1,023 calendar days). From a statistical point of view, the stock market is going up far more often than it decreases.
Additionally, as previously noted, the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have a rich history of rising over long periods of time. The S&P 500 Index has not declined in any rolling 20-year period, including dividends, since 1900, according to data from Crestmont Research.
In another context, however bleak the short-term outlook for the stock market may be, the S&P 500 has managed to scale this wall of worry each time. Even if stocks fall in the not-too-distant future, long-term optimists will rest easy.
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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 securities mentioned. The Motley Fool has a disclosure policy.
The stock market is doing something for only the fifth time in 30 years, and the story is crystal clear on what’s next for stocks. was originally published by The Motley Fool
