It can be an unpleasant realization for new investors, or perhaps a not-so-subtle reminder for tenured investors, but stock market corrections, crashes, and bear markets are a normal part of the long-term investing cycle.
Over the past 73 years, there have been 39 separate instances where the benchmark S&P 500 (^GSPC 1.20%) declined by a double-digit percentage, which works to an average of one correction every 1.87 years. Last year was one such instance, with the Dow Jones Industrial Average (^DJI 0.69%), S&P 500, and Nasdaq Composite (^IXIC 1.59%) all falling into a bear market and delivering their worst full-year returns since the financial crisis.
Image source: Getty Images.
But what new and tenured investors really want to know is where stocks will head next. While there's no specific indicator or metric that's foolproof when it comes to forecasting stock movements -- if there was, we'd all be using it to get rich -- there are indicators and metrics that have impressive track records over short periods of predicting which direction the market will move.
At the moment, two time-tested valuation metrics with infallible track records over the past 25 years have a very clear message for where stocks will head next.
This valuation tool hasn't been wrong, under certain parameters, dating back to 1870
The first valuation tool that has an impeccable track record of forecasting where stocks will head next is the S&P Shiller price-to-earnings (P/E) ratio, which is also referred to as the cyclically adjusted price-to-earnings ratio, or CAPE ratio.
With the more traditional P/E ratio, a company's trailing-12-month earnings are compared to its current share price. Meanwhile, the Shiller P/E ratio is based on average inflation-adjusted earnings over the past 10 years.
Back-testing all the way to 1870, the Shiller P/E ratio has averaged about 17. Over the past quarter of a century, the Shiller P/E has spent a considerable amount of time above 25, with historically low lending rates and ease of access to financial information coercing investors to take risks and pay higher premiums for growth stocks.
S&P 500 Shiller CAPE Ratio data by YCharts.
Where the Shiller P/E ratio has previously signaled trouble is when it surpasses and holds above 30. This has happened only five times since 1870 during a bull market. Four of those occasions have occurred in the past quarter of a century: the dot-com bubble, the second half of 2018, leading up to the COVID-19 crash, and throughout 2021 leading into the first week of 2022. When valuations are extended with a Shiller P/E north of 30, the eventual response is a decline in the S&P 500 of at least 20%.
In February, the Shiller P/E surpassed 30 yet again. While this valuation tool doesn't have a particularly good track record of forecasting when downtrends happen in stocks -- i.e., valuations can stay extended for some time -- it does have a history of eventually calling double-digit declines when valuations get above a certain threshold (in this instance, a Shiller P/E above 30).
This metric has been a valuable tool for opportunistic investors for 25 years
The second valuation tool with an impeccable track record of predicting where stocks will head next is the S&P 500's forward P/E ratio. A forward P/E ratio compares a company's (or index's) share price relative to Wall Street's consensus earnings estimate for the coming (i.e., forward) year.
Over the past quarter of a century, there have been four bear markets and a multitude of double-digit percentage corrections. Understanding where the S&P 500's forward P/E ratio has bottomed during previous corrections and bear markets provides a data set that can help investors predict where future declines may find their bottom.
For the past 25 years, no bear market or sizable market correction has bottomed out with a forward P/E ratio higher than 14. With the exception of the financial crisis (2007-2009) and a correction in 2011, every bear market and sizable correction for the past 25 years has seen the S&P 500 bottom out with a forward P/E ratio of between 13 and 14.
As of the closing bell on March 21, the S&P 500's forward P/E ratio was 17.6. While that's not abnormally high, in context to the past 25 years, it is notably higher than we'd look for with regard to what the historical data tells us. When the Dow, Nasdaq Composite, and S&P 500 hit their nadir for 2022, the S&P 500's forward P/E never fell below roughly 15.5.
The inference, based on a quarter century of valuation data, is that the bear market won't find its bottom until the S&P 500's forward P/E ratio deflates. Given the growing likelihood of a U.S. recession, and the negative impact economic downturns tend to have on corporate earnings, the S&P 500's forward P/E ratio would suggest that stocks are headed lower.
Image source: Getty Images.
The key metrics long-term investors can trust
Based on these two valuation-based metrics, the likeliest direction stocks will head in the current bear market is lower.
However -- and this is a pretty big "however," so pay close attention -- these aren't the only metrics with some serious weight and history behind them. There are practical guarantees that suggest long-term investors are extremely wise to continue putting their money to work on Wall Street, even with near-term uncertainty over the direction of the stock market.
One undeniable fact is that every correction, crash, and bear market throughout history, excluding the ongoing bear market, has eventually been wiped away by a bull market rally. Even though we won't know ahead of time how long a downdraft in stocks will last or how steep the decline will be, history conclusively shows that the losses in the Dow, Nasdaq, and S&P 500 are eventually recouped (and then some) by a bull market.
Data that's refreshed annually by market analytics company Crestmont Research also confirms that long-term investors are smart to continue putting their money to work on Wall Street.
Every year, Crestmont examines the rolling 20-year total returns, including dividends paid, of the S&P 500 since 1900. Of the 104 ending years examined (1919-2022), every single one produced a positive annualized return. In simpler terms, if you, hypothetically, bought an S&P 500 tracking index at any point since 1900 and held that position for 20 years, you made money every single time. It's a testament to the value of using time as your ally, and it's all the convincing you should need to continue investing for the future.
