On a year-to-year basis, the stock market is unpredictable, as investors were reminded firsthand in 2022. Following a nearly unstoppable move to new highs in 2021, the ageless Dow Jones Industrial Average (^DJI +0.66%), benchmark S&P 500 (^GSPC +1.18%), and growth stock-fueled Nasdaq Composite (^IXIC +1.96%), all fell into respective bear markets last year and generated their worst returns since 2008.
Meanwhile, the start to 2023 has been just the opposite. As of the closing bell on Feb. 16, the S&P 500 and Nasdaq were higher by 6.5% and 13.3%, respectively. It has a lot of investors rightly questioning if the worst is behind us.
However, one telltale bear market indicator, which has a foolproof track record when backdated to 1870, would beg to differ with that assumption.
Image source: Getty Images.
This bear market forecasting tool has never been wrong
Although there is no shortage of bear market predictors for everyday and professional investors to rely on, the Shiller price-to-earnings (P/E) ratio (also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio) has an impeccable track record of forecasting downside on Wall Street. Whereas a traditional P/E ratio compares the share price of a stock to its trailing-12-month earnings, the Shiller P/E ratio is based on average inflation-adjusted earnings over the previous 10 years.
While the S&P 500's Shiller P/E ratio hasn't predicted every bear market or big-time decline in the broad-based index, there is a line-in-the-sand level where, when crossed, sizable declines have followed every single time.
Dating back to 1870, there have been only five instances when the Shiller P/E ratio surpassed 30 during a bull market and held above this level for a reasonable amount of time:
- 1929: At the peak just prior to the Great Depression, the Shiller P/E tipped the scales above 30. The Dow Jones Industrial Average would eventually lose 89% of its value before bottoming out.
- 1997-2001: The dot-com bubble featured the highest Shiller P/E reading on record (44.19). After peaking, the S&P 500 shed 49% of its value, with the Nasdaq getting hit even harder.
- Q3 2018: During the third quarter of 2018, the Shiller P/E crested 30, once again. The fourth quarter of 2018 featured a 19.8% maximum decline in the S&P 500. While not officially a bear market (20% is the line-in-the-sand threshold), it does round to a 20% decline.
- Q4 2019-Q1 2020: In the months prior to the coronavirus crash in February/March 2020, the S&P Shiller P/E ratio topped 30 once more. The COVID-19-induced crash knocked 34% off of the S&P 500 in just 33 calendar days.
- Q3 2020-Q2 2022: Lastly, the Shiller P/E ratio got as high as 40 during the first week of January 2022, which is when the S&P 500 and Dow Jones topped. The S&P 500 lost as much as 28% of its value since hitting its record high.
S&P 500 Shiller CAPE Ratio data by YCharts.
This month, the S&P Shiller P/E is, once more, back above 30. Although we're not in a bull market -- surpassing 30 during a bull market has previously been the recipe for at least an eventual 20% decline -- history is quite clear that a Shiller P/E above 30 isn't well tolerated by Wall Street.
To build on this point, significant declines in the S&P 500 over the past quarter-century have usually found their bottom with the Shiller P/E around 22, give or take a little bit in each direction. Even with the S&P 500 declining as much as 28% last year from peak to trough, it didn't approach this typical valuation support level.
Lastly, a number of high-profile stocks have been lowering their 2023 full-year guidance to correspond with certain weakening economic indicators. According to data from FactSet, 82% of the 71 S&P 500 companies that issued first-quarter guidance, as of Feb. 10, 2023, came in with a forecast below Wall Street's consensus. As the likelihood of a U.S. recession grows, investors' willingness to pay a premium for stocks should taper.
In other words, all signs point to the broader market being pricey. Earnings estimates for the S&P 500 falling, coupled with the Shiller P/E ratio rising, is an unfavorable combination that portends downside to come in the stock market.
Image source: Getty Images.
This bit of history is foolproof, too, and it favors long-term optimists
But there are two sides to this coin. While the Shiller P/E ratio has an immaculate track record of forecasting downside in stocks when valuations get extended, long-term investors can take comfort in another aspect of investing history that's undefeated.
Every year, financial market and economic research company Crestmont Research releases data on the rolling 20-year total returns, including dividends paid, for the S&P 500. This data release hypothetically examines what your average annual total return would be if you bought an S&P 500 tracking index at any point since 1900 and held for 20 years.
The result? You would have made money every single time, regardless of when you made your initial purchase. Only a small handful of the 104 ending years examined between 1919 and 2022 produced an annualized total return of 5% or less. Meanwhile, around 40% of the end years examined generated an annualized total return of between 10.8% and 17.1% over 20 years. In short, if you buy an S&P 500 tracking index and allow time to be your ally, history suggests you'll make money.
Although there are no guarantees for individual stocks, gravitating to dividend-paying companies is also, usually, a smart move. Publicly traded stocks that pay a dividend are typically profitable on a recurring basis and have proven their ability to navigate bear markets and/or economic downturns.
What's more, dividend stocks have a rich history of crushing nonpayers in the return department. According to a report issued 10 years ago by J.P. Morgan Asset Management, a division of money-center bank JPMorgan Chase, companies that initiated and grew their payouts between 1972 and 2012 delivered an average annual return of 9.5% over this four-decade period. The stocks not offering a payout produced a meager annualized return of 1.6% between 1972 and 2012.
If time is on your side, not even this telltale bear market signal for stocks should scare you from putting money to work in high-quality businesses and/or index funds.
