Since a bad inflation report last week, stocks have suddenly rallied for no obvious reason, making many investors wonder if the brutal bear market that has ensued for most of the year is over.
After all, the S&P 500, a broader benchmark for the overall market, is still down more than 23% and is only about 11.8% higher than pre-pandemic levels in 2020. Over two years, it would not be at all irregular to see the market make these kinds of gains.
But according to several indicators that have reliably predicted the end of a bear market several times in the past, the selling may not be done just yet.
Of course, the past doesn't always correctly predict the future, and the market today is certainly dealing with conditions not seen before. But that doesn't mean we should completely ignore what these two telling indicators are saying right now.
1. S&P 500 forward P/E ratio
The forward price-to-earnings (P/E) ratio is typically used by investors to examine how expensive an individual stock is. You take the stock price or market cap of a company and divide it by the following year's projected earnings per share or net income to arrive at the forward P/E ratio.
Image source: Getty Images.
A high P/E can indicate that a stock is expensive, while a low P/E can say it's cheap, although it's dependent on the industry, peer group, and what kind of stock it might be (value vs. growth) to make a proper determination.
In this case, we can look at the combined forward P/E ratio of all of the companies in the S&P 500. Currently, that ratio stands at just above 17.
But during most market bottoms over the last two decades -- barring the Great Recession -- the forward P/E ratio of the S&P 500 has been around 13 or 14 during a market bottom. This includes during the bottom of the dot-com crash in 2002, late in 2018 after a big market pullback into bear territory, and after a huge decline in the market during the pandemic in 2020.
2. The "fear gauge"
Another way investors have looked for market bottoms in the past is by using an indicator called the Chicago Board Options Exchange Volatility Index, or VIX for short, which is also known as the "fear gauge."
The VIX is calculated by looking at and combining the prices of S&P 500 put and call options over the next 30 days to essentially look at how much market volatility investors are expecting over the next 30 days.
In general, when the VIX is below 20, that means there is less uncertainty and calmer conditions in the market, which is why the S&P 500 tends to rise. When the VIX is above 30, there is a lot of uncertainty in the environment, which is why the market tends to fall. The VIX and the S&P 500 tend to have an inverse relationship.
As you can see in the chart above, when the VIX spiked to all-time highs, like in 2008-2009 during the Great Recession and in early 2020 during the very beginning of the pandemic, it also pretty much lined up with a market bottom. Similarly, when the VIX was very low in late 2021, the market peaked.
Currently, the VIX is at about 32, signaling heightened volatility. But Adam Kobeissi, founder of The Kobeissi Letter, a newsletter covering the capital markets, said earlier this year that "historically speaking, no bear market has ever bottomed without a VIX reading of 45 or more."
But a VIX of 45 or more hasn't always signaled a bottom. In late 2018, the market bottomed when the VIX was at a lower point than it's at now. So, it can happen, although I'm not sure there was the same amount of concern over a recession that economists have now.
