Investing in 2022 has been an adventure, to say the least. Since hitting record-closing highs during the first week of January, the timeless Dow Jones Industrial Average (^DJI 0.23%) and benchmark S&P 500 (^GSPC -0.16%) shed as much as 19% and 24% of their respective value. For the growth-focused Nasdaq Composite (^IXIC -0.50%), we’re talking about an even steeper decline that exceeded 30%. You’ll note by the magnitude of these declines that the S&P 500 and Nasdaq officially entered a bear market.
But over the past roughly seven weeks, Wall Street has staged a rally. Since June 16, 2022, the Dow Jones, S&P 500, and Nasdaq Composite have respectively risen by 9.6%, 13.3%, and 19%, through August 3. Bear market over, right? I don’t know fast.
Three data points suggest this is nothing more than a bear market rally, with potentially lower lows to come. However, it’s not all bad news, with investors having one reason to be exceedingly optimistic about their portfolios.
1. The Shiller P/E ratio offers an ominous warning
One of the biggest warning signs at the moment can be found with the S&P 500’s Shiller price-to-earnings (P/E) ratio (also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio). Whereas a traditional P/E ratio examines share price relative to trailing-12-month earnings, the Shiller P/E looks at inflation-adjusted earnings over the past 10 years.
Without beating around the bush, anytime the S&P 500’s Shiller P/E ratio has crossed above and sustained 30, bad things have happened. Although ease-of-access to information has improved dramatically over the past quarter of a century due to the internet, and investors are, therefore, willing to accept higher valuation premiums, the Shiller P/E has a perfect track record of calling bear markets dating all the way back to 1870.
In these 152 years of recordkeeping, there have been only five bull market rallies that took the S&P 500’s Shiller P/E above 30 on a sustained basis. Following the peak of each of these bull markets, the S&P 500 went on to lose anywhere from 20% to 89% of its value. While a Great Depression-like 89% loss is almost certainly out of the question today due to fiscal and monetary measures, a bear market decline has been the minimum expectation when valuations get extended.
The silver lining is that the S&P 500 has already entered a bear market, with an aforementioned peak decline of 24%. However, the Shiller P/E ratio remains at an elevated reading of 31.17, as of Aug. 3, 2022. History would suggest this valuation premium needs to fall reasonably below 30 for the market to find a bottom.
2. A big valuation indicator is breaking down
The second indicator which suggests the current bear market has yet to reach its bottom is the S&P 500’s forward P/E ratio. A “forward” P/E ratio divides a company’s share price (or index’s total value, in this instance) into Wall Street’s forecast earnings for the upcoming year.
Since 1999, the broad-based S&P 500 has found a bottom when its forward P/E ratio hit anywhere from 13 to 14 on multiple occasions. This is the valuation level where the dot-com bubble in 2002, fourth quarter plunge in 2018, and coronavirus crash in 2020, found their respective bottoms.
The problem is that the S&P 500 is currently valued at approximately 17 times forward-year earnings. While this in no way screams “overvalued,” it’s above where we would expect valuations to be, from a historical standpoint, if they were finding a bottom. For added context, the forward P/E ratio of the S&P 500 dipped as low as the mid-15s in mid-June 2022.
The bigger concern is that the ‘e’ component, earnings, is beginning to break down. Many of the largest companies within the S&P 500 have warned that their bottom line is likely to take a hit in the second half of 2022, or is already feeling the effects. With earnings estimates falling, the S&P 500’s forward P/E could eventually be a lot higher than the current figure implies.
3. Margin debt tells the tale
The third indicator that still spells trouble ahead for the Dow, S&P 500, and Nasdaq is margin debt. “Margin debt” being the amount of money borrowed by investors from their online brokerage, with interest, to buy or short-sell securities.
A rising amount of outstanding margin debt is not necessarily a red flag for the stock market. As the aggregate value of publicly traded stocks rises over time, it is perfectly normal to see outstanding margin debt increase in steps. What’s not normal is when margin debt skyrockets in a very short period.
Since 1995, there have been three instances where margin debt increased by 60% or more in a 12-month time frame. It occurred immediately prior to the dot-com bubble bursting, just months in advance of the financial crisis kicking off, and in 2021. In each of the previous two instances where margin debt (ergo, risk-taking) rose in a short time frame , the S&P 500 lost in the neighborhood of half of its value. We’ve come nowhere near close to those loss levels in 2022.
Additionally, the two previous times the S&P 500 lost half of its value, we witnessed margin debt decline by 40% to 50% on a year-over-year basis. As of June 2022, margin debt has declined by about 20% from the prior-year period. This would suggest additional margin covering and/or margin calls await.
Investors are batting 1,000 if they do this
Although the short-term picture being painted for the Dow, S&P 500, and Nasdaq, based on this data, isn’t exactly positive, there’s still one big reason for long-term investors to be exceedingly optimistic: patience pays on Wall Street.
Since the beginning of 1950, there have been 39 double-digit percentage corrections in the S&P 500, according to data collected by market analytics firm Yardeni Research. With the exception of our current decline, each and every one of the previous 38 dips were eventually cleared away by a bull market rally. Although we can’t predict how long it’ll take for the stock market to completely recover its losses, history has conclusively shown that optimistic investors benefit from the natural expansion of the US economy and growth in American/global businesses, when examined as a whole.
What’s more, an annually published report from Crestmont Research demonstrates just that how much of an ally time has been for patient investors. Crestmont’s report examined the rolling 20-year total returns, including dividends, of the S&P 500 for every ending year between 1919 and 2021 (103 ending years in total).
The results showed that all 103 final years delivered a positive total return. Whereas just a couple of years ended with average annual total returns of 5% or less spanning 20 years, there were more than 40 end years where the average annual total return surpassed 10%. Put another way, when you buy into the stock market matters far less than how long you hold.
While near-term volatility in the broader market can be unnerving, and bear market swoons can be unpredictable, the data unequivocally shows that now is as perfect a time as any to buy high-quality, innovative companies at a discount that you can hold for a long time to come.