Every now and then, Wall Street provides a not-so-subtle reminder to the investing community that stocks can go lower.
Since hitting all-time highs between mid-November 2021 and the first week of January 2022, the timeless Dow Jones Industrial Average (^DJI 0.59%)widely followed S&P 500 (^GSPC 0.48%)and equity-driven growth Nasdaq Composite (^IXIC 0.01%) decreased by as much as 22%, 28%, and 38%, respectively. This means that all three major US indices have at least briefly experienced a bear market in 2022.
No matter how long you’ve been invested, bear markets can make you question your resolve to stay the course. In particular, in the bear market of 2022, many people are wondering where the bottom might be. While no single indicator, metric, or statistic has accurately predicted the beginning or end of every bear market, one bear market indicator has an exceptionally strong track record of warning investors.
This bear market metric points to more trouble for Wall Street
Looking back to 1870, the S&P 500 Shiller price-to-earnings (P/E) ratio predicts the arrival of five bear markets. The Shiller P/E, also known as the cyclically adjusted price-to-earnings ratio (CAPE ratio), takes into account inflation-adjusted earnings over the previous 10 years.
While on the surface the Shiller P/E is just another valuation tool, it accurately predicted the coming bear market every time it went above 30 and held that level. This includes a peak above 30 in 1929 on the eve of the Great Depression, 44 during the dot-com bubble, exceeding 30 in the third quarter of 2018 and just before the coronavirus crash, and again (briefly) exceeding 40 during the first week of 2022. The short version is that every time the S&P Shiller P/E ratio hits 30 during a bull market, the S&P 500 eventually follows a decline of at least 20% (key word, “eventually”).
But the Shiller P/E ratio can be an equally useful predictor of where a bear market will bottom out. With the exception of the financial crisis (2007-2009), the number of double-digit percentage pullbacks in the S&P 500 over the past quarter-century bottomed out when the S&P 500 Shiller P/E hit 22 (give or take). a point or two in each direction). This is not so surprising given that professional and everyday investors often become more critical of stock valuations during market downturns.
I’m sorry to say, but this telltale bear market indicator once again sounds a warning that the broader market has yet to bottom out – at least if history proves correct. The latest bounce after lower-than-expected U.S. inflation briefly pushed the S&P Shiller back above 29. While anything is possible, no bear market has ever bottomed out with a Shiller P/E like it is now.
Considering that a number of high-profile companies have started to moderate their outlook, all signs seem to point to a bumpy road ahead in late 2022 and/or early 2023.
This “warning” is your opportunity to attack
Although the S&P Shiller P/E ratio has a proven track record of being accurate, it is not perfect. But there is something that has a perfect track record: the S&P 500 itself.
As I pointed out earlier, time is an investor’s greatest ally. Trying to predict where the market will be a year from now is nothing but bullshit. However, the longer you hold, the better your chances of getting it right and building wealth.
According to data compiled by market analytics firm Crestmont Research, there has not been a 20-year rolling period since 1900 in which the S&P 500 has failed to deliver a positive total return, including dividends paid. In other words, if you hypothetically bought and held the S&P 500 tracking index for 20 years, you made money 103 out of 103 times (each year from 1919 to 2021 represents the closing years for these current 20-year periods). Most of the time, investors made a ton of money, with more than 40% of these 103 trailing years resulting in an average annual total return of at least 10.8%.
If you’re worried about “getting in too early,” consider this: there have been 39 separate double-digit percentage declines in the S&P 500 since the start of 1950. With the exception of the current bear market, all 38 of the previous crashes corrected, and bear markets were eventually removed by a bull market. . Once again, it doesn’t matter when you buy, as long as you give your investment(s) enough time to play out and prove your point.
I should also say that this is not unique to the S&P 500. Every crash, correction, and bear market in the Dow Jones Industrial Average and Nasdaq Composite has also been ultimately rejected by bull markets.
In short, if Shiller’s P/E ratio sounds like a warning, it’s often a great time for opportunistic long-term investors to pounce.