As the past couple of years have shown, volatility is a fixture on Wall Street. The ageless Dow Jones Industrial Average (^DJI 0.40%), benchmark S&P 500 (^GSPC 1.02%), and innovation-driven Nasdaq Composite (^IXIC 2.02%), have navigated two bear markets since the start of the decade, and enjoyed a period of investment euphoria, which sent all three indexes to record-closing highs in late 2021 or early 2022.
The prevailing question on investors' minds right now isn't a mystery. They want to know where the Dow Jones, S&P 500, and Nasdaq Composite, are headed next after three-and-a-half very volatile years. This simple question has reignited Wall Street's oldest battle and pitted those in the "this, too, won't last" camp against the investors who believe "this, too, shall pass."
Image source: Getty Images.
This, too, won't last
During Berkshire Hathaway's (BRK.A -0.76%) (BRK.B -0.69%) annual shareholder meeting in early May, CEO and billionaire investor Warren Buffett proclaimed that the "incredible period" for the U.S. economy was coming to an end. While Buffett would never bet against America -- this is a point he's made several times in previous Berkshire Hathaway shareholder meetings and investment letters -- he's smart enough to recognize that near-term headwinds are building for the U.S. economy.
Investing skeptics are taking a realistic look at these mounting headwinds and coming to the conclusion that Wall Street's 2022 bear market may not be in the rearview mirror just yet. In other words, "this, too, won't last," with regard to the strong rally in the S&P 500 and Nasdaq Composite since 2023 began.
Take the S&P 500's Shiller price-to-earnings (P/E) ratio as a good example. The Shiller P/E, which is also commonly known as the cyclically adjusted price-to-earnings ratio (CAPE ratio), is based on average inflation-adjusted earnings over the previous 10 years. Accounting for 10 years' worth of corporate earnings history ensures that one-year fluctuations won't skew this metric.
S&P 500 Shiller CAPE Ratio data by YCharts.
When back-tested to 1870, the S&P 500's Shiller P/E has averaged 17.05. However, it's spent almost the entirety of the past 30 years above this mark, largely because of the internet tearing down barriers to entry for everyday investors. Information can now be accessed by anyone with the click of a button. This, along with a long period of historically low lending rates, fueled risk-taking from everyday investors.
As of the closing bell on Aug. 24, 2023, the Shiller P/E closed at 30.18. There have been only six instances in 153 years where the Shiller P/E has surpassed 30. The previous five instances all ended with the Dow Jones Industrial Average or S&P 500 losing at least 20% of their value. Extended valuations simply aren't sustainable over long periods.
Likewise, the broader market rally in 2023 has been fueled by the euphoria surrounding Wall Street's next-big-thing investment: artificial intelligence (AI). A PwC report from earlier this year estimates that AI could add $15.7 trillion to the global economy by 2030.
Demand for AI solutions is especially visible for Nvidia (NVDA 6.18%), the company that controls the lion's share of AI-driven graphics processing units (GPUs) used in high-compute data centers. Nvidia recorded 141% sales growth in data-center revenue from the previous quarter (ended April 30), with its data center operations accounting for $10.3 billion of its $13.5 billion in July quarter sales.
Unfortunately, next-big-thing investments have a history of disappointing investors. While it's tough to say anything bad about Nvidia following its second blowout quarter in a row, no one is exactly sure what an AI driven world looks like. History teaches us that all next-big-thing investments need time to mature, and that bubbles are commonplace in the early stages of euphoria. In short, this, too, won't last.
This, too, shall pass
There is no shortage of reasons to believe that Wall Street's major stock indexes are headed lower in the short term. From valuation concerns to simply following the money, headwinds are mounting.
But this skepticism represents just one opinion on Wall Street. The other group of investors, which fall into the "this, too, shall pass" camp, are playing a simple numbers game that values patience over timing.
Although Wall Street has proven highly unpredictable when examined over days, weeks, months, or even a couple of years, things come into crystal-clear focus the more investors widen their lens.
Image source: Getty Images.
For instance, "this, too, shall pass" investors are fully aware that stock market corrections, bear markets, and even crashes, are a normal part of the investing cycle. Since the start of 1950, the S&P 500 has undergone 39 separate corrections that hit the double-digit percentage mark. On average, this works out to a meaningful decline every 1.89 years.
However, what's just as common for Wall Street's major indexes is recouping their losses following corrections, bear markets, and crashes. With the exception of the 2022 bear market, every single downturn in the major indexes dating back to their inception was eventually cleared away by a bull market. While it's true that we'll never know ahead of time when these declines will start, how long they'll last, or how steep they'll ultimately be, history is pretty clear that the Dow, S&P 500, and Nasdaq Composite are going to achieve new highs when examined over multidecade periods.
The ability of Wall Street to deliver sizable returns to patient investors is precisely what market research company Crestmont Research analyzed when it examined the rolling 20-year total returns, including dividends, of the S&P 500.
What makes Crestmont's dataset so compelling is that researchers were able to back-test the S&P 500's rolling 20-year total returns to 1900. Even though the S&P didn't exist until 1923, its components could be found in other indexes between 1900 and 1923, which allowed for even more accurate datapoints. All told, Crestmont gathered annualized total return data for 104 rolling 20-year periods (1919-2022).
The results of Crestmont's extensive research showed that 104 out of 104 ending years produced a positive total return. It hasn't mattered when you've put your money to work on Wall Street as long as you've stuck around for the long run to see your investment thesis play out.
Further, more than 50 of these 104 two-decade periods examined produced an annualized return of at least 9%. In other words, investors aren't just scraping by with menial gains. If you allow your investments to grow via compounding, you've often crushed the prevailing inflation rate and generated sizable real-money returns.
While I fully agree that current valuations on Wall Street and AI euphoria simply can't last, this period of uncertainty shall pass.
