This has been a year that's tested the resolve of professional and everyday investors alike. The first half of the year saw the benchmark S&P 500 (^GSPC -0.46%) produce its worst return since 1970. Meanwhile, the growth-stock-driven Nasdaq Composite (^IXIC -0.64%), which was largely responsible for pushing the broader market to new highs, has plunged as much as 34% since hitting its mid-November record close.
With the S&P 500 and Nasdaq respectively declining 24% and 34%, respectively, at their peaks, both indexes have firmly entered bear market territory. Given the heightened volatility and uncertainty that accompanies bear markets, it has a lot of investors wondering where the market will bottom.
Officially, we have no clue. If there was an indicator that was right 100% of the time, everyone would be using it. But we do have two valuation indicators that have a pretty successful track record of calling bear market bottoms.
Image source: Getty Images.
The S&P 500's forward P/E ratio has been fairly accurate at predicting bottoms
The first valuation indicator that has a pretty good track record of calling bear market bottoms is the S&P 500's forward price-to-earnings (P/E) ratio. Whereas a traditional P/E ratio examines trailing earnings over a 12-month period, a forward P/E ratio divides the price of a security (in this instance, the point value of the S&P 500 Index) into Wall Street's consensus forecast earnings for the upcoming fiscal year.
Since the mid-1990s, the S&P 500 has had a number of sizable pullbacks, including the dot-com bubble, financial crisis, the coronavirus crash, and even the fourth-quarter tumble of 2018, which saw the index shed 20% of its value. With the exception of the financial crisis (2007-2009) and a sizable double-digit percentage correction in 2011, the S&P 500's forward P/E ratio has consistently found a bottom between 13 and 14.
As of Sept. 21, 2022, the S&P 500's forward P/E ratio was 15.9. Based on where the S&P 500 has been valued this century, this is a pretty inexpensive forward-year valuation. But based on what history tells us, this forward P/E would need to fall by an additional 11.95% to 18.24% for the S&P 500 to hit a bear market bottom. In point value terms, we're talking about a bottom in the range of 3,098.65 on the low side to 3,337.03 on the upside.
But keep in mind that that the S&P 500's forward P/E ratio is subject to change. With the U.S. economy delivering back-to-back quarters of declining gross domestic product, it's possible corporate earnings will need to be revised much lower, on the whole.
S&P 500 Shiller CAPE Ratio data by YCharts.
The Shiller P/E ratio portends a bit more downside
The other valuation indicator of interest actually does have a perfect track record of calling bear markets. I'm talking about the S&P 500's Shiller P/E ratio, which is also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio. Unlike a traditional P/E ratio, the Shiller P/E examines inflation-adjusted earnings over the past 10 years.
Since 1870, there have been only five instances where the Shiller P/E ratio has surpassed and sustained a reading of 30. While there's no specific length of time that the Shiller P/E stayed above 30 in these five instances, the result was all the same: an eventual bear market. Here's how the previous five instances have shaken out:
- 1929: After Black Tuesday, the iconic Dow Jones Industrial Average (^DJI -0.98%) went on to lose as much as 89% during the Great Depression
- 1997-2001: Following an all-time high Shiller P/E reading of 44.19, the dot-com bubble erased 49% of the S&P 500's value.
- Q3 2018: After surpassing a Shiller P/E of 30, the S&P 500 lost 20% of its value during the fourth quarter of 2018.
- Q4 2019-Q1 2020: With the Shiller P/E once again above 30, the coronavirus crash resulted in a peak loss of 34% for the S&P 500.
- Q3 2020-Q2 2022: The Shiller P/E peaked at 40 in January 2022. Since then, the S&P 500 has lost as much as 24% of its value.
Over the past quarter of a century, the stock market has tended to bottom out with a Shiller P/E of around 22. With the Shiller P/E sitting at 28.13, as of Sept. 22, 2022, there's the expectation of additional downside of nearly 22%. This would imply a bottom for the S&P 500 of 2,939.12.
In other words, two leading valuation indicators with a pretty good track record of calling bear market bottoms suggest the S&P 500's bear market bottom could occur between a range of 2,939.12 and 3,337.03.
Image source: Getty Images.
This bit of history is undefeated
But there's another side to this story. While bear markets can be scary and test the resolve of investors to stick around, history conclusively shows that buying during these sizable downturns is a genius move.
Every year, market analytics company Crestmont Research releases data that examines the 20-year rolling total returns, including dividends paid, of the S&P 500. This data, which is expressed as an annual average total return over 20 years, includes 103 separate end years (1919 through 2021). For example, the rolling 20-year returns for 1958 would include every year from 1939 through 1958, expressed as an average annual total return.
What you might be surprised to learn is that if an investor purchased an S&P 500 tracking index at any point since Jan. 1, 1900 and held that position for 20 years, they generated a positive total return for all 103 end years. Approximately 40% of the 103 end years produced an average total return of at least 10.9%. In other words, investors doubled their money about every seven years during these two-decade stretches.
Conversely, only a small number of end years produced annual average total returns of less than 5%. Even then, investors walked away with a clearly positive total return.
No matter what the stock market throws investors' way over the short run, history is quite clear that buying and holding equities for extended periods of time is a trusted moneymaking formula.
