Over the last two months, Wall Street has offered investors a not-so-subtle reminder that stocks do, in fact, move in both directions.
Since the benchmark S&P 500(SNPINDEX: ^GSPC) peaked on Feb. 19, the famous Dow Jones Industrial Average(DJINDICES: ^DJI), S&P 500, and growth stock-oriented Nasdaq Composite(NASDAQINDEX: ^IXIC) have respectively lost 12.3%, 14%, and 18.8% of their value, as of the closing bell on April 17. The double-digit percentage declines for the Dow and S&P 500 place both indexes in correction territory, while the Nasdaq Composite has, as of its lowest closing value on April 8, firmly fallen into a bear market.
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This historic stock market volatility is a reflection of investors' fear and uncertainty concerning President Donald Trump's "Liberation Day" tariff announcements, the growing prospect of the U.S. economy dipping into a recession, and rapidly rising Treasury yields, which threaten to increase borrowing costs for consumers and businesses.
But the big question on the minds of investors is: "Will the S&P 500 follow in the Nasdaq Composite's footsteps and enter a bear market?"
Image source: Getty Images.
Although no guarantees exist when forecasting short-term directional moves for the S&P 500, one valuation tool with over 150 years of back-tested data in its sails has an uncanny ability, under rare circumstances, to accurately predict short-term directional moves in Wall Street's benchmark index.
This ultra-rare event has historically been a precursor to downside in the S&P 500
Valuation is a bit of a tricky subject to discuss, given that everyone's definitions of "cheap" and "pricey" differ. Nevertheless, most investors tend to rely on the time-tested price-to-earnings (P/E) ratio to quickly determine whether a stock, or the broader market, is trading at an attractive valuation.
The P/E ratio is calculated by dividing a company's share price by its trailing-12-month earnings per share (EPS). Generally, a lower P/E ratio signifies a more attractively valued stock.
But the P/E ratio isn't perfect. While it's an excellent screening tool for mature businesses, it doesn't factor in growth rates for fast-paced companies. Additionally, it's a metric that gets easily tripped up by shock events and periods of economic turbulence. For instance, corporate earnings tumbled during the early stages of the COVID-19 pandemic, which rendered the traditional P/E ratio relatively useless.
The metric that offers a much more comprehensive look at valuations, and which has a phenomenal track record of forecasting short-term directional moves in the S&P 500 under a very specific (and rare) set of circumstances, is the S&P 500's Shiller P/E ratio. You may also see the Shiller P/E referred to as the cyclically adjusted P/E ratio, or CAPE ratio.
Unlike the traditional P/E ratio, which is based on trailing-12-month EPS, the Shiller P/E accounts for average inflation-adjusted EPS over the prior 10 years. Adjusting for inflation and examining a decade's worth of earnings history ensures that shock events and recessions don't demonstrably impact this valuation tool.
In December, the S&P 500's Shiller P/E ratio peaked at a closing multiple of 38.89 during the current bull market cycle. For context, this reading was more than double the average multiple of 17.23, when back-tested to January 1871. It's also the third-highest reading during a bull market cycle, surpassed only by the dot-com bubble (which peaked at 44.19 in December 1999) and the first week of January 2022 (with a reading of just above 40).
Following a 14% decline in the S&P 500, the Shiller P/E ended April 17 at a reading of 32.66. While this is notably lower than the multiple of almost 39 recorded in December, Wall Street's widely followed index has never bottomed at a reading north of 30.
Covering a span of 154 years, the S&P 500's Shiller P/E has only surpassed 30 for at least two consecutive months six times, including the present. In all five previous instances, the S&P 500, Dow Jones Industrial Average, and/or Nasdaq Composite lost, at minimum, 20% of their respective value.
Based on the last three decades of Shiller P/E valuation data, the average bottom following a period of extended premiums for stocks is a reading in the neighborhood of 22. Conservatively, this would place the S&P 500 roughly 39% below its all-time closing high.
While this does not guarantee that the S&P 500 will decline by 39% on a peak-to-trough basis, it does offer a strong historical correlation indicating that the S&P 500 is highly likely to follow the Nasdaq Composite into a bear market.
Image source: Getty Images.
The silver lining: Significant stock market downturns are surefire buying opportunities
The prospect of the Dow Jones, S&P 500, and Nasdaq Composite potentially breaking well below their April 8 closing lows may not be what some investors want to hear. But there is a silver lining to historical data -- and it far outweighs any near-term downside for Wall Street's major stock indexes.
For example, the S&P 500 has just endured its 12th-largest four-day decline when looking back 75 years -- a 12.1% drop from April 3 through April 8. Since 1950, there have been only 15 instances where the broad-based index lost between 11.5% and 28.5% of its value over four trading sessions. Though these periods were often marked by heightened fear and uncertainty, they were surefire buying opportunities for investors.
According to Charlie Bilello, the chief market strategist at Creative Planning, who aggregated data on the S&P 500's worst four-day returns since 1950, the benchmark index was higher at the one-, three-, and five-year marks following all 14 previous instances.
What's more, the S&P 500's total return, including dividends, following historically large moves lower was well above average. One, three, and five years later, the S&P 500 generated average total returns of 33.8%, 49%, and 112.1%, respectively. In comparison, the S&P 500 has delivered an annualized return of around 10% over the long run.
To sweeten the pot even more for long-term investors, there's a night-and-day difference between bear and bull markets on Wall Street.
In June 2023, shortly after the S&P 500 was confirmed to be in a new bull market, researchers at Bespoke Investment Group published a data set to X that compared the lengths of every S&P 500 bull and bear market dating back to the start of the Great Depression (September 1929).
On the one hand, the typical bear market for the S&P 500 resolved in 286 calendar days, or about 9.5 months. Further, no bear market since the Great Depression has endured longer than 630 calendar days.
On the other hand, the average S&P 500 bull market (as of June 8, 2023) has lasted for 1,011 calendar days, which is approximately 3.5 times longer than the mean bear market. Additionally, if the current bull market were extrapolated to present day, 14 out of 27 S&P 500 bull markets over the last 95-plus years have lasted longer than the lengthiest bear market.
In other words, Wall Street's darkest days often present the brightest opportunities 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.
