Every so often, Wall Street offers a stern reminder to investors that stocks don't rise in a straight line. Following a greater than two-year rally in the Dow Jones Industrial Average(DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite(NASDAQINDEX: ^IXIC), stock market skeptics are making their presence known.
Since Feb. 19, the benchmark S&P 500 entered correction territory with a loss of 12.2% (as of April 3), while the Nasdaq Composite has shed 18% of its value since notching its record-closing high on Dec. 16.
Double-digit percentage declines in two of Wall Street's three primary stock indexes -- the Dow is just few points away from joining them -- are primarily being fueled by uncertainty related to President Donald Trump's tariff policy. On April 2, which Trump affably labeled as "Liberation Day," he introduced sweeping global tariffs, as well as reciprocal tariffs on countries that have historically run trade imbalances with the U.S.
Image source: Getty Images.
Historically, tariff announcements have weighed on stocks. A Liberty Street Economics study authored by four New York Fed economists found that companies exposed to Trump's China tariffs in 2018-2019 performed worse on tariff announcement days than those without exposure. Furthermore, these companies also endured worse future outcomes, including average declines in their sales, profits, employment, and labor productivity from 2019 to 2021.
While the recent corrections in the S&P 500 and Nasdaq Composite might have investors believing stocks are becoming cheaper, a trusted valuation tool with more than 154 years of back-tested data in its sails suggests this couldn't be further from the truth.
The reality is that stocks are still historically pricey
To preface this discussion, value is a subjective term. Although we have valuation metrics and data points that we can compare to other stocks or indexes, the definition of what's "cheap" or "pricey" isn't going to be the same from one investor to the next.
Nevertheless, some valuation tools offer undeniable correlations that tend to cut through investor's subjectivity.
Most investors tend to rely on the time-tested price-to-earnings (P/E) ratio when assessing the relative cheapness or priciness of a publicly traded company. Dividing a company's share price by its trailing-12-month earnings per share (EPS) will lead you to its P/E ratio. This calculation often works great for mature businesses, but it can struggle when assessing growth stocks, as well as during periods of economic disruption.
The valuation tool that's been far more reliable when assessing the priciness of the stock market is the S&P 500's Shiller P/E Ratio, which is also sometimes referred to as the cyclically adjusted P/E Ratio (CAPE Ratio). The Shiller P/E relies on average inflation-adjusted EPS over 10 years, which means short-term shock events aren't a concern.
Despite corrections in the S&P 500 and Nasdaq Composite, the S&P 500's Shiller P/E clocked in at a multiple of 33.52, as of April 3. Though this is down from a peak closing value of 38.89 in December, it's still more than double the average multiple of 17.22, when back-tested to January 1871.
Dating back 154 years, you'll find only six instances (including the present) where the Shiller P/E surpassed 30 during a bull market cycle and held this mark for a period of at least two months. While there's no particular rhyme or reason as to how long the S&P 500's Shiller P/E remains elevated above 30, the end result of the previous five occurrences has always been a decline of between 20% and 89% in the Dow, S&P 500, and/or Nasdaq Composite.
Over the last three decades, the Shiller P/E has typically found its valuation trough at an average multiple of approximately 22. While this isn't to say it couldn't bottom at 26, as it did during the 2022 bear market, a retracement from 38.89 to 33.52 in no way signals that the stock market has become attractive on a valuation basis.
Image source: Getty Images.
History also provides a silver lining
Thankfully, history isn't a complete downer when it comes to putting your money to work on Wall Street. Just as the historical valuation data for the Shiller P/E portends ongoing trouble for equities, a wider-lens approach offers promise.
Hiccups for the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite are probably more common than you realize. Based on data collected by Yardeni Research, 10% declines in the S&P 500 have occurred every roughly 1.9 years spanning the last eight decades. These corrections, which can turn into bear markets, are normal, inevitable, and a healthy aspect of the investing cycle.
But most importantly, stock market corrections and bear markets have a history of being short-lived.
Nearly two years ago, shortly after the S&P 500 was confirmed to have entered a new bull market, the analysts at Bespoke Investment Group shared a data set on X that compared to length of every S&P 500 bull and bear market dating back to September 1929. This starting point is no coincidence -- it's the beginning of the Great Depression.
Bespoke's data examined 27 bear markets and found that the average downturn of at least 20% lasted 286 calendar days. In comparison, the typical bull market covering 94 years endured for 1,011 calendar days, or approximately 3.5 times as long.
Additionally, Bespoke's data set made clear that bull markets consistently last longer than even the worst situations thrown Wall Street's way. During the mid-1970s, the S&P 500's longest bear market stuck around for 630 calendar days. But inclusive of the current bull market, 14 out of 27 S&P 500 bull markets have lasted longer than 630 calendar days.
Even though stock valuations remain historically pricey, and there's a high probability we'll witness the Dow, S&P 500, and Nasdaq Composite move lower over the short-term, the statistical returns data overwhelmingly favors all three indexes moving substantially higher over time. In other words, stock market corrections beget opportunity for patient investors.
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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.
