Let's face the ugly truth: It's been one of the most challenging years on record for Wall Street and the investing community. The benchmark S&P 500 (^GSPC 0.03%) delivered its worst first-half return in more than a half-century, while the growth-dependent Nasdaq Composite (^IXIC -0.28%) lost nearly a third of its value.
What could go wrong seemingly has. Global supply chains remain challenged by the COVID-19 pandemic and Russia's invasion of Ukraine, and the U.S. inflation rate hit yet another four-decade high of 9.1% in June. Whereas the Federal Reserve often comes to the rescue of tumbling equity markets, it now has no choice but to aggressively raise interest rates to tame inflation. It's a never-before-seen scenario that's led to a historically awful performance for equities.
But the big question remains: How far could the stock market plunge?
This indicator suggests a market bottom could be closer than you think
Superficially, no one knows that answer. If there were a way to know ahead of time when a stock market correction would occur, how long it would last, and how steep the decline would be, everyone would be retired and sipping on margaritas right about now.
But just because we can't precisely predict the answers to the above, it doesn't mean history doesn't rhyme from time to time. One indicator has proved particularly adept at calling the S&P 500's bottom fairly accurately during most major pullbacks since the mid-1990s. Based on this indicator, the broad-based S&P 500 could be closer to a bottom than most folks realize.
The indicator in question is the S&P 500's forward-year price-to-earnings (P/E) ratio. In simple terms, this involves dividing the S&P 500 Index into Wall Street's forecast earnings per share for the index in the upcoming year (in this case, 2023).
During the coronavirus crash of 2020, the fourth-quarter pullback of 2018, and the end of the dot-com bubble in 2002, the S&P 500's forward P/E ratio bottomed out between 13 and 14 each time. It's worth noting that the S&P 500's forward P/E ratio pushed well below 13 during the financial crisis of 2008-2009 (like I said, no indicator is perfect). However, there's a big difference between the entire financial system struggling and the U.S. economy facing a slowdown or recession. We look to be leaning toward the latter and not the former at the moment.
If the S&P 500 were to, again, find a bottom at a multiple of 13 to 14 times Wall Street's forward-year earnings forecast, it would imply additional downside ranging from 11.9% to 18.2%, based on a forward P/E ratio of 15.9, as of July 13, 2022. This works out to a bottom in the neighborhood of 3,110 to 3,350 on the S&P 500.
While that might still sound like a ways off, I'd point out that the S&P 500 is already 1,000 points below its all-time high. As long as the "e" component, earnings, doesn't fluctuate too much going forward, the index is just 450 points to 690 points from reaching its projected bottom. In other words, the worst of the decline is probably in the rearview mirror; and that's a potentially good thing for investors' psyche.
Three smart ways to invest in a bear market
Although the velocity and unpredictability of downside moves during a bear market can be unnerving and rightly tug at investors' heartstrings, history is quite clear that putting your money to work during these downturns is a smart move. As a reminder, each of the 38 previous double-digit percentage declines in the S&P 500 since the beginning of 1950 were eventually cleared away by a bull market rally.
For example, buying dividend stocks is a smart way of putting your money to work during periods of heightened volatility. Companies that regularly pay a dividend to their shareholders are often profitable on a recurring basis and are likely time-tested. Perhaps even more important, income stocks have historically run circles around non-dividend payers in the return department over multiple decades. In other words, boring dividend stocks can be an investor's best friend during a bear market pullback.
Secondly, it's never a bad idea to consider putting your money to work in companies that provide a basic necessity good or service. For instance, just because inflation is soaring and consumers are worried about the economy in the near-term, it doesn't mean homeowners are going to stop using electricity or quit buying food. Utility stocks and nondiscretionary good and service providers are often a smart place to turn when uncertainty becomes deafening.
A third smart way to invest in a bear market is by keeping it simple with an index fund. The Vanguard S&P 500 ETF (VOO 0.04%) effectively mirrors the price action of the S&P 500 index for a minuscule annual expense ratio of 0.03%. That's only a $0.30 fee for every $1,000 you invest.
If you're wondering why I chose an S&P 500 index fund, consider this: There hasn't been a rolling 20-year period since 1900 where the S&P 500 didn't deliver a positive total return, including dividends, to investors. If you buy an S&P 500 tracking index, such as the Vanguard S&P 500 ETF, and hold that index for 20 years, history has shown you'll make money 100% of the time. This makes bear market pullbacks an especially astute time to put your money to work in an S&P 500 tracking index.