This Telltale Bear Market Indicator Is Sounding a Warning, Once Again

From time to time, Wall Street offers a not-so-little reminder to the investment community that stocks can move lower.

Since reaching their final highs between mid-November 2021 and the first week of January 2022, ageless Dow Jones industrial average (^DJI 0.59%)widely followed S&P 500 (^ GSPC 0.48%)and growth-driven stock Nasdaq Composite (^IXIC 0.01%) respectively dropped as much as 22%, 28%, and 38%. This means that the three major US indices had at least a brief taste of a bear market in 2022.

A visibly worried person looking at a rapidly rising stock chart displayed on a tablet.

Image source: Getty Images.

No matter how long you’ve been investing, bear markets can make you lose track of your resolve to stay the course. In particular, many people in the 2022 bear market are wondering where the bottom might be. While no indicator, metric, or statistic accurately predicts the beginning or end of every bear market, one notable bear market indicator has a very strong track record of providing investors with early warnings.

This market metric points to more trouble ahead for Wall Street

Looking back as far as 1870, Shiller’s S&P 500 price-to-earnings ratio (P/E) has predicted five bear markets. The Shiller P/E, also known as the cyclically adjusted price-to-earnings ratio (CAPE ratio), takes into account inflation-adjusted earnings from the previous 10 years.

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Although the Shiller P/E is just another valuation tool on the surface, it is accurately predicted that a bear market will occur anytime it crosses above 30 and sustains that level. This includes a peak of over 30 in 1929 before the Great Depression, peaking at 44 during the dot-com bubble, going over 30 in the third quarter of 2018 and just before the coronavirus crash, and again (briefly) going over 40 during the The first week of 2022. The short version is that the S&P Shiller P/E ratio will rise 30 times during a bull market, a decline in the S&P 500 of at least 20% eventually follows ( keyword, “finally”).

S&P 500 CAPE Shiller Ratio Chart

S&P 500 Shiller CAPE Ratio Data at YCharts.

But the Shiller P/E ratio can be just as useful a forecast when a bear market is set up. With the exception of the financial crisis (2007-2009), double-digit percentage numbers in the S&P 500 over the past quarter century found their roots when the S&P 500 Shiller P/E hit 22 (give or take a point or two in each direction). That’s not surprising since professional and everyday investors often become more critical of stock valuations during bear market downturns.

I’m sorry to say, but this erratic bear market indicator is, once again, a warning that the broader market is yet to bottom out – at least if history is accurate. The latest bounce following a lower-than-expected US inflation rate briefly pushed the S&P Shiller back above 29. While anything can be done, the Shiller P/E has never been a bear market as high as it is now.

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Considering that some high-profile companies have started to moderate their expectations, all signs seem to point to a very narrow road for equities until late 2022 and/or early 2023.

A smirking businessman holding a financial newspaper.

Image source: Getty Images.

This “warning” is your chance to pounce

While the S&P Shiller P/E ratio has a time-tested track record, it is not perfect. But there is something that has a perfect track record: The S&P 500 itself.

As I have pointed out before, time is the greatest ally of investors. Trying to predict where the market will be a year from now is nothing more than a crapshoot. However, the longer you hold, the more likely you are to be right and build wealth.

According to data compiled by market analytics company Crestmont Research, there hasn’t been a rolling 20-year period since 1900 when the S&P 500 has failed to deliver a positive total return, including dividends paid. In other words, if you hypothetically bought and held the S&P 500 tracking index for 20 years, you made money 103 out of 103 times (with each year from 1919 to 2021 representing the final years for these 20-year rolling periods) . Most of the time, investors made a boatload of money, with more than 40% of the last 103 years resulting in an average annual total return of at least 10.8%.

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If you’re worried about “getting in too soon,” consider this: There have been 39 separate double-digit percentage declines in the S&P 500 since the start of 1950. With the exception of the current bear market, all 38 were prior crashes. this, corrections, and bear markets finally cleared by a bull market. Once again, it really doesn’t matter When you buy, as long as you give your investment(s) enough time to play out and prove your thesis properly.

I should also say that this is not unique to the S&P 500. The bull markets also gave away every crash, correction and mark in the Dow Jones Industrial Average and Nasdaq Composite.

In short, if the Shiller P/E ratio is a warning, it’s often a great time for long-term investors to take advantage.

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