Over long periods, the stock market is an undisputed source of money. Compared to other asset classes, such as bonds, oil, gold and housing, the stock market has generated a significantly higher annualized rate of return over the long term.
However, the performance of the eternal. Dow Jones Industrial Average (DJINDICES: ^DJI)broad based S&P 500 (SNPINDEX: ^GSPC)and driven by innovation Nasdaq Composite (NASDAQ INDEX: ^IXIC) it becomes much less certain when examined over the course of a few months to a couple of years. For example, the three major stock indices have oscillated between bullish and bear markets in successive years since this decade began.
Image source: Getty Images.
When volatility spikes, it's not uncommon for investors to look for data points or predictive tools that can offer a clue as to where stocks will head next. While there is no one metric that is foolproof when it comes to predicting short-term directional moves in the Dow Jones, S&P 500, and Nasdaq Composite, there are a handful of forecasting tools and data points that have strongly correlated with up and down movements in major indices through history.
One such widely followed metric, with a phenomenal track record dating back more than a century, is currently flirting with danger. The question is: Does this closely followed data indicate the possibility of an imminent stock market crash in 2024?
Historically, this is a harbinger of bad news for Wall Street.
The valuation tool that investors are probably most familiar with is the price-earnings ratio (P/E). The P/E ratio is an easy-to-use measure that divides a publicly traded company's stock price by its trailing 12-month earnings per share.
However, the P/E ratio may be susceptible to wild swings due to unforeseen events, such as the COVID-19 pandemic. That's why many smart investors also follow the Shiller P/E ratio of the S&P 500. Note: The Shiller P/E is also commonly known as the cyclically adjusted price-to-earnings ratio (CAPE ratio).
Shiller's P/E is based on average inflation-adjusted earnings over the prior 10 years. Examining inflation-adjusted earnings over a full decade smooths out fluctuations in corporate operating performance that may be seen in one or two outlier years.
S&P 500 Shiller CAPE Ratio data for Y Charts.
When backtested to 1870, the S&P 500's Shiller P/E had an average multiple of 17.07. But as you can see from the chart above, it has spent almost all its time above this level for the last 30 years. The advent of the Internet, which democratized access to information and the ability of everyday investors to put their money to work on Wall Street, along with historically low interest rates, has fueled multiple expansions and investors' willingness to take risks .
But there is always a limit to risk-taking.
For the last 154 years, there have only been six cases where the S&P 500's Shiller P/E surpassed 30 during a bull market rally. The five cases above were harbingers of bad news for Wall Street:
- 1929: Shiller's backtested P/E was above 30 before the Black Monday accident of October 1929. The Dow Jones ended up losing 89% of its value after this peak.
- 1997-2001: Shiller's P/E reached its all-time high of 44.19 in December 1999, leading to the dot-com bubble. The S&P 500 lost 49% of its value and the Nasdaq was hit even harder.
- First quarter of 2018-Third quarter of 2018: Shiller's P/E surpassed 30, once again, in 2018. In a difficult fourth quarter for Wall Street in 2018, the S&P 500 fell 20%.
- Fourth quarter of 2019-First quarter of 2020: The fourth instance of Shiller's P/E exceeding 30 came to an end when the COVID-19 crisis hit in February-March 2020. The S&P 500 lost 33% of its value in less than five weeks.
- Q3 2020-Q2 2022: Shiller's P/E crossed 40 during the first week of January 2022. After this peak, the Dow, S&P 500, and Nasdaq Composite entered a bear market, with the S&P 500 losing up to 25% of its worth.
- Q1 2023-current: The S&P 500 Shiller P/E was above 32 at the close on December 20.
The five cases above with a Shiller P/E ratio greater than 30 have eventually (keyword!) resulted in the S&P 500 losing at least 20% of its valuewhich is traditionally the basic definition of a bear market.
Note that this does not mean that a stock market crash is imminent in 2024. As you will notice by looking at the period from 1997 to 2001, valuations can remain stretched for an indeterminate period of time. Although in the end, valuation does matterwhich has led to major bear markets for the Dow, S&P 500, and Nasdaq Composite.
If history rhymed again, 2024 has the potential to be a challenging year for investors.
Image source: Getty Images.
Perspective changes everything.
But the funny thing about Wall Street is that The investor's perspective changes everything.. For a short-term trader, Shiller's P/E is one of several metrics currently warning of potential trouble ahead for the stock. However, for long-term-minded investors, crises tend to be blessings in disguise.
Since the early 1950s, there have been 39 separate double-digit percentage declines in the S&P 500. This is equivalent to a correction, on average, every 1.9 years. But with the exception of the 2022 bear market, all previous corrections, declines and bear markets was finally cleared by a bull market rally.
Although we will never know in advance when corrections will begin, how long they will last, or how steep the decline will be, history has conclusively shown that major indices eventually recover their losses and reach new all-time highs. . In practice, this makes every notable decline in the Dow Jones, S&P 500, and Nasdaq Composite a buying opportunity for patient investors.
Researchers at Bespoke Investment Group took this analysis a step further when they examined the average duration of bull and bear markets for the S&P 500 dating back to the start of the Great Depression in September 1929. During this 94-year period, Bespoke identified 27 different markets. bull and bear markets for Wall Street's widely followed index.
It's official. A new bull market is confirmed.
The S&P 500 is now up 20% from its closing low of 10/12/22. In the previous bear market, the index fell 25.4% in 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
- Bespoke (@bespokeinvest) June 8, 2023
The average S&P 500 bear market has lasted 286 calendar days (about 9.5 months), with no downturn exceeding 630 calendar days (January 11, 1973 โ October 3, 1974). In comparison, the The average S&P 500 bull market has endured 1,011 calendar days (approximately two years and nine months), with 13 of 27 bull markets lasting longer than the longest bear market. In other words, being bullish is undeniably profitable on Wall Street.
An even more comprehensive study from Crestmont Research, which analyzed 123 years of total return data for the S&P 500, further demonstrates the power of time and perspective on Wall Street.
Crestmont researchers analyzed 20-year rolling total returns, including dividends, of the S&P 500, dating back to 1900. Although the S&P did not exist until 1923, its components could be found in other major indices before this point. This made it relatively easy for analysts to backtest back to 1900 and emerge with 104 consecutive 20-year periods of total return data for the S&P 500 (1919-2022).
The surprising conclusion is that all 104 periods produced a positive total return. Regardless of when an investor would have hypothetically put his money to work, he would have increased his wealth if he had maintained that position in the S&P 500 for 20 years. The thing is, no matter what happens in 2024, the needle always seems to point higher for optimistic investors willing to use time to their advantage.
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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 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.
