There's no beating around the bush: This has been one of the roughest starts to a year in stock market history. Since each of the three respective major U.S. indexes hit their all-time closing highs, the iconic Dow Jones Industrial Average (^DJI 0.16%), benchmark S&P 500 (^GSPC +0.80%), and growth-driven Nasdaq Composite (^IXIC +1.63%) have plunged by as much as 19%, 24%, and 34%, respectively, through June 20, 2022.
With peak-to-trough declines well in excess of 20%, the Nasdaq and S&P 500 are firmly entrenched in a bear market. That's particularly bad news because the Nasdaq had been leading the broader market higher and the S&P 500 is widely viewed as the best barometer of U.S. stock market health.
Unfortunately, the broader market's steep sell-off may not be over. Even with the S&P 500 down by 24%, three indicators suggest it has further to fall.
Image source: Getty Images.
Margin debt portends more downside
If there's a single economic indicator that's most worrisome for the stock market and investors, it's outstanding margin debt. "Margin debt" is the amount of money investors are borrowing, with interest, to purchase or bet against securities.
As the total value of all tradable securities increases over time, it's perfectly normal to see outstanding margin debt increase in lockstep. What isn't normal is when margin debt skyrockets higher in a very short time frame. In the previous instances where margin debt has climbed by at least 60% in a 12-month time frame, the S&P 500 has fallen off a cliff not long after.
Between March 1999 and March 2000, margin debt climbed by about 80%. This rapid jump in leverage effectively marked the peak of the dot-com bubble, which saw the S&P 500 lose roughly half of its value amid the longest bear market in its history (929 calendar days).
It was a similar story between June 2006 and June 2007, when margin debt rose by 62%. This jump in leverage preceded the financial crisis and Great Recession by mere months. The S&P 500 eventually lost 57% of its value.
And once again, margin debt skyrocketed 72% between March 2020 and March 2021. If history serves as a guide, huge increases in outstanding leverage tend to halve the S&P 500.
S&P 500 Shiller CAPE Ratio data by YCharts.
The S&P 500 Shiller P/E has a perfect track record when predicting bear markets
However, margin debt is far from the only concerning indicator for the broader market. The S&P 500 Shiller price-to-earnings (P/E) ratio comes with its own unique set of warnings. Note, the Shiller P/E ratio is also commonly referred to as the cyclically adjusted price-to-earnings ratio, or CAPE ratio.
Whereas the traditional P/E ratio examines trailing-12-month earnings, the Shiller P/E factors in inflation-adjusted earnings over the past 10 years. Dating all the way back to 1870, the Shiller P/E has averaged a reading of nearly 17. In January, when the S&P 500 hit its all-time closing high, the S&P 500 Shiller P/E ratio was above 40.
In the 152-year time span between 1870 and 2022, the Shiller P/E ratio has surpassed and held 30 on five separate occasions. Eventually, each and every one of these instances where valuations became extended led to a bear market decline in the S&P 500. In late 2018, the index "only" lost 20% of its value. Meanwhile, the broader market shed close to 90% of its value during the Great Depression.
History has shown that simply getting the S&P 500 Shiller P/E ratio back below 30 often isn't enough to quell additional downside in the broader market. Bear markets in recent decades have typically resulted in the Shiller P/E ratio bottoming in the low 20s. This would imply peak downside of around 40% in the S&P 500, assuming the "e" component, earnings, isn't hurt too drastically by a potential recession.
Image source: Getty Images.
The S&P 500's forward P/E ratio offers a precedent
The Shiller P/E ratio isn't the only valuation metric that can offer some level of precedent when bear markets occur. A simple review of the S&P 500's forward-year P/E ratio can lend plenty of insight, as well.
As of the end of last week, the broad-based S&P 500 was valued at a multiple of 15.4 times Wall Street's forecast earnings for 2023. That's down from a multiple of closer to 23 times forward earnings, which was set in the second-half of 2020.
Although a multiple of 15.4 times Wall Street's forecast earnings for the upcoming year sounds more than reasonable and is more or less the average forward-year valuation for the S&P 500 over the past 23 years, history would suggest it's not the bottom. The March 2020 coronavirus crash, the fourth-quarter decline in 2018 of 20%, and the dot-com bubble (which found its bottom in 2002) all ended with the S&P 500 at a forward-year earnings multiple of between 13 and 14.
If the S&P 500 were to retrace to a forward P/E multiple of 13 to 14, it would still have about 10% to 15% additional downside from where it closed last week.
Patience pays off handsomely for long-term investors and bear market buyers. ^SPX data by YCharts.
Now for the good news
Although these indicators offer clues as to what may come next for the most widely followed U.S. stock index, there's no foolproof sign. If there was an economic indicator or metric that told Wall Street and investors what equities would do next with complete accuracy, everyone would be using it.
Perhaps the more important takeaway should be that every bear market throughout history has proved to be an incredible buying opportunity for patient investors. Every double-digit percentage decline in the Dow Jones, S&P 500, and Nasdaq Composite has, eventually, been wiped away by a bull market rally. While some declines, unquestionably, take longer to recoup than others, the point remains unchanged: long-term optimism is a moneymaking strategy.
With the Nasdaq and S&P 500 firmly in a bear market, there are a number of smart strategies investors can employ to increase their likelihood of making money.
As an example, dividend stocks have an exemplary long-term track record. Companies that regularly pay a dividend are typically profitable and have often navigated multiple economic downturns. Additionally, long-term studies have shown that income stocks have vastly outpaced stocks that don't pay dividends.
Seeking the safety of defensive stocks can be a smart move, as well. Just because the stock market has struggled in 2022 doesn't mean consumers are suddenly not buying food or beverages or cancelling their utility services. People also don't stop getting sick and requiring medical care just because Wall Street has gone through a rough stretch. Buying stakes in defensive companies can be profitable in both bull and bear markets.
