For much of the past year, investing in the stock market has required an iron stomach. The unprecedented nature of the coronavirus disease 2019 (COVID-19) pandemic turned societal norms on their heads, brought an end to the traditional work environment, and cast a dark cloud over equities during the first quarter of 2020. It took just 33 calendar days (less than five weeks) for the benchmark S&P 500 (^GSPC 0.65%) to lose more than a third of its value.
Then again, it's been mostly a roller coaster of joy since the March 23 bottom. The S&P 500 finished 2020 higher by 16% (that's nearly double its average annual return over the last 40 years), and it's begun 2021 on a high note. Through Wednesday, Feb. 3, the widely followed index was higher by 2%, year to date.
But if history proves accurate, investors shouldn't get too comfortable with 2021's strong start.
Be prepared for a 20% stock market crash
Although day trading and momentum chasing seem to be ruling the roost in the first few weeks of the new year, it's operating earnings growth that drives equity valuations sustainably higher over the long run. That's why it's always important to pay attention to market-based fundamentals, no matter what's going on.
The figure that should have investors pretty concerned is the Shiller price-to-earnings (P/E) ratio for the S&P 500. This differs from the standard P/E ratio in that it's based on average inflation-adjusted earnings from the previous 10 years, as opposed to just earnings from a single year.
Looking back 150 years, the S&P 500 has averaged a Shiller P/E of 16.78. Admittedly, the Shiller P/E ratio has been a lot higher over the past 25 years. The advent of the internet has broken down information barriers for retail investors, and historically low lending rates for more than a decade have fueled borrowing and lit a fire under growth stocks.
But as of Feb. 3, the Shiller P/E for the S&P 500 was knocking on the door of 35 -- more than double the long-term average. To put this figure into some context, there have only been five periods in history where the Shiller P/E ratio topped 30 and stayed there during a bull market run. Two of these events -- the Great Depression and dot-com bubble -- led to some of the biggest pullbacks ever witnessed in equities. Two other events (not counting the current move) occurred within the past three years, delivering declines of 20% and 34%, respectively, in the S&P 500.
In other words, anytime the Shiller P/E ratio crosses above and sustains 30 in a bull market rally, it's eventually resulted in a minimum decline of 20%.
There are other reasons to be concerned
It's not just stretched valuations that are of concern at the moment. Nosebleed premiums baked into the stock market assume that the COVID-19 pandemic will soon be a thing of the past. This may not prove to be the case.
As an example, take a gander at the latest COVID-19 vaccine survey results from Kaiser Family Foundation (KFF). In mid-January, KFF asked respondents about their willingness to receive at least one dose of a COVID-19 vaccine for free. Some 6% were already vaccinated, with another 41% willing to get it as soon as they could. Meanwhile, nearly a third (31%) of respondents were in "wait-and-see" mode, with a combined 20% either "definitely not getting it" or getting it only if required (note, figures don't add to 100% due to rounding).
That's pretty much half of the population that's unwilling to get in line for a COVID-19 vaccine right now. According to recent comments from Dr. Anthony Fauci, it would take between 70% and 85% vaccination rates to achieve herd immunity. In other words, the pandemic could be far from over.
To build on this point, many working Americans and their families are counting on continued assistance from the federal government. Millions of workers have been laid off or furloughed, and some of those who are still working have seen their hours cut. If partisan bickering continues on Capitol Hill and additional fiscal stimulus is delayed, it could have seriously negative consequences on consumption (that's the leading driver of U.S. gross domestic product) and might lead to a substantial increase in loan and credit delinquencies. That would be bad news for financial stocks, which many consider to be the backbone of the U.S. equity markets.
Stay the course and target winners
Nevertheless, even if a stock market crash is brewing, it's a smart move for investors to stay the course and add to innovative and winning businesses.
One of the most telling statistics about stock market plunges comes courtesy of J.P. Morgan Asset Management. Having analyzed 20-year rolling returns for the S&P 500 with multiple different end-years, one figure stands out: Roughly 50% to 60% of the market's best single-session gains occur within a few weeks of its worst single-session performances. This is a fancy way of saying that if you run for the exit, you're almost certainly going to miss out on some of the market's biggest up days. Missing out on even a handful of these big up days can be detrimental to your wealth.
Additionally, data from Crestmont Research shows that there hasn't been a trailing 20-year period in the S&P 500's history where investors would have lost money. If an investor purchased an S&P 500 tracking index and held on for at least 20 years, they typically averaged a high single-digit or low double-digit annual total return (i.e. including dividends).
If a stock market crash rears its head in 2021, the best game plan is to stay the course and add to holdings that keep winning.