There's no two ways about it: This has been the most-challenging year for investors in decades. Since hitting their respective intra-day highs between mid-November and the first week of January, the timeless Dow Jones Industrial Average (^DJI +0.40%), broad-based S&P 500 (^GSPC +0.29%), and growth-driven Nasdaq Composite (^IXIC +0.60%), have lost as much as 22%, 26%, and 34% of their value. That places all three major U.S. stock indexes in the grips of a bear market.
Although bear markets are an excellent opportunity to put your money to work (I'll touch on this in more detail a bit later), they can also be scary. The unpredictability and velocity of moves lower during bear markets are enough to test the resolve of even the most-tenured investors.
Worse yet, there may be substantial downside still to come in the Dow, S&P 500, and Nasdaq.
Image source: Getty Images.
This bear market indicator has a perfect track record
Wall Street professionals and everyday investors use dozens of indexes, indicators, and economic data points to determine where the stock market will head next. However, only one indicator has a perfect track record of calling bear markets: the S&P 500 Shiller price-to-earnings (P/E) ratio, which is also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio.
Whereas the traditional P/E ratio divides a company's share price into its trailing-12-month earnings per share, the S&P Shiller P/E takes into account inflation-adjusted earnings over the past 10 years. In other words, it's a bit more encompassing than the traditional P/E ratio.
Since 1870, there have been only five instances where the S&P Shiller P/E ratio has eclipsed and sustained a reading of 30. Following each and every one of these peaks, the S&P 500 fell at least 20% (when rounded).
- 1929: After the Black Tuesday crash, the Dow Jones Industrial Average went on to lose up to 89% of its value during the Great Depression.
- 1997-2001: In the years leading up to the dot-com bubble, the Shiller P/E ratio hit an all-time high of approximately 44.2. In the following two-and-a-half years, the S&P 500 lost 49% of its value, with the Nasdaq getting hit much harder.
- Q3 2018: The Shiller P/E ratio crested above (and held) 30 once again, during the second half of 2018. During the fourth quarter of 2018, the benchmark S&P 500 dove 19.8%, which rounds to a 20% decline -- the official percentage cutoff where a bear market begins.
- Q4 2019-Q1 2020: The S&P Shiller P/E ratio topped 30 once more, prior to the coronavirus crash in February-March 2020. The S&P 500 then shed a peak of 34% of its value in just 33 calendar days.
- Q3 2020-Q2 2022: During the first week of January 2022, the S&P Shiller P/E ratio surpassed 40 for the first time since the dot-com bubble. Since then, the benchmark index has lost as much as 26% of its value.
It's worth pointing out that the S&P Shiller P/E ratio has been consistently higher than its historic average (16.98) over the past quarter of a century. This can likely be attributed to the advent of the internet and the democratization of information. With income statements, balance sheets, press releases, and the ability to buy and sell stock available at the click of a button, Wall Street and investors have been more willing to tolerate risk and higher valuations than in the past.
Nevertheless, this telltale indicator has predicted five bear markets without fail.
S&P 500 Shiller CAPE Ratio data by YCharts.
It also has an impressive history of calling bear market bottoms
In addition to predicting bear markets, the S&P Shiller P/E ratio done a pretty good job of forecasting bear market bottoms, too. While no indicator is foolproof at calling bear market bottoms, the Shiller P/E ratio has demonstrated success.
While a Shiller P/E ratio of 30 seems to be the magic number that portends an eventual bear market, a pullback to a Shiller P/E ratio of approximately 22 has historically been where bear markets find their support. The coronavirus crash in 2020 saw the Shiller P/E plummet from around 34 to 22 before finding firmer ground. Likewise, the Shiller P/E ratio was effectively halved from 44 to 22 during the dot-com bubble.
What would a Shiller P/E ratio of 22 look like today? Considering the Shiller P/E ratio ended Oct. 5, 2022, at 28.32, an additional 22.32% downside would be necessary in the S&P 500 to bring it to a level where support has been found during prior bear markets. This would entail the S&P 500 dropping by 844.43 points to 2,938.85. All told, this would represent a peak-to-trough bear market decline of 39%.
Yet, once again, no bear market bottom indicator is perfect. During the Great Depression and Great Recession (2007-2009), the Shiller P/E ratio went far, far below 22. But thanks to available monetary and fiscal tools, a Great Depression-esque 89% plummet in the Dow Jones, or any other major index, would be extremely unlikely today.
Image source: Getty Images.
Here's why you're a genius for buying during a bear market decline
However, there is an investment strategy that's been nothing short of foolproof for over a century -- and all it requires is patience.
Every year, market analytics company Crestmont Research publishes data it's collected on the rolling 20-year total returns, including dividends paid, of the S&P 500 dating back to 1900. In simple terms, Crestmont is examining what the average annual total return would be if an investor bought and held an S&P 500 tracking index for 20 years. For example, the rolling 20-year total return for 1971 would include years 1952 through 1971, and it would be expressed as an average annual total return over this 20-year stretch.
In total, Crestmont examined the rolling 20-year total returns for 103 end years (1919-2021). Every single one of these 103 end years would have made investors richer. Approximately 40% of these 103 end years produced an average annual total return of 10.9% to 17.1%. Comparatively, fewer than five years produced average annual total returns ranging between 3.1% and 5%. In other words, buying and holding an S&P 500 tracking index didn't just make investors money -- it often made them a lot of money.
When given enough time, every single stock market correction and bear market is wiped away by a bull market rally. The current bear market will eventually share that same fate. This is why putting your money to work during the current decline is such a genius move.
