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Is the Stock Market on a Collision Course With History? More Than a Century of Data Tells the Tale.

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Historic correlations bode poorly for Wall Street.

For more than two years, optimists have been running the show on Wall Street. Since 2022 came to a close, the mature-stock-powered Dow Jones Industrial Average (^DJI -1.69%), broad-based S&P 500 (^GSPC -1.71%), and growth-propelled Nasdaq Composite (^IXIC -2.20%) have respectively risen by 35%, 60%, and 92% as of the closing bell on Feb. 19.

Wall Street’s bull market has been fueled by a confluence of factors including:

But while catalysts have been abundant, the stock market appears to be on a collision course with history.

Image source: Getty Images.

Over 150 years of valuation history spells trouble for Wall Street

Though there are always going to be predictive indicators or data points that portend trouble for the U.S. economy or stock market — e.g., the first notable decline in U.S. M2 money supply since the Great Depression occurred in 2023 — perhaps nothing is sounding a warning quite like one of Wall Street’s valuation tools.

When most investors think about valuation, the price-to-earnings (P/E) ratio probably comes to mind. The P/E ratio, a company’s share price divided by its trailing-12-month earnings per share, offers a quick way for investors to assess the priciness of a stock relative to its peers and the broader market. Unfortunately, the P/E ratio can be easily tripped up by growth stocks and shock events/economic downturns.

A far more accurate measure of the stock market’s relative priciness is the S&P 500’s Shiller P/E ratio, also known as the cyclically adjusted P/E ratio (CAPE ratio). The Shiller P/E is based on average inflation-adjusted earnings from the prior 10 years, which means shock events and recessions won’t skew the results as they can with the traditional P/E ratio.

Although the Shiller P/E didn’t gain acclaim until the late 1990s, it’s a valuation tool that’s been back-tested 154 years.

S&P 500 Shiller CAPE Ratio data by YCharts.

As of the closing bell on Feb. 19, the S&P 500’s Shiller P/E clocked in at 38.75, which is just shy of its highest reading (38.89) during the current bull market rally and more than double the average reading of 17.21 since January 1871.

The current bull market marks only the third time in history the S&P 500’s Shiller P/E has surpassed 38, the other two being December 1999 (44.19) and the first week of January 2022 (just above 40). The all-time high reading preceded the bursting of the dot-com bubble, which wiped out 49% of the S&P 500’s value and 78% of the Nasdaq Composite on a peak-to-trough basis. The January 2022 top marked the start of the most recent bear market.

Since 1871, there have been only six instances, including the present, when the Shiller P/E has surpassed 30 for at least two consecutive months. Following each of the previous five occurrences, the Dow Jones Industrial Average, S&P 500, and/or Nasdaq Composite all shed between 20% and 89% of their value.

Warren Buffett’s “best single measure” of valuations serves an ominous warning

To be clear, the S&P 500’s Shiller P/E Ratio isn’t the only valuation tool that’s sounding a warning on Wall Street. A valuation measure that Berkshire Hathaway CEO Warren Buffett referred to in a 2001 interview with Fortune magazine as “probably the best single measure of where valuations stand at any given moment” is also making dubious history.

This measure, which has become known as the “Buffett Indicator,” is the total market cap of all U.S. stocks divided by U.S. gross domestic product (GDP). When back-tested to 1970, the Buffett Indicator has averaged a reading of 85% — i.e., the total value of all stocks equals roughly 85% of U.S. GDP.

This past week, the Buffett Indicator hit an all-time high of 207.24%, which represents a roughly 144% premium to this valuation measure’s 55-year average. Adjusting for fourth-quarter GDP data, it’s even higher than when Barchart pointed out the Buffet Indicator’s prior all-time high in December.

Previous jumps in the Buffett Indicator that were (at the time) well above its historic average eventually boded poorly for the stock market. For example, it peaked above 195% just before the 2022 bear market took shape, and hit more than 166% before the COVID-19 crash began.

Although neither the Shiller P/E Ratio nor the Buffett Indicator is in any way a timing tool, they do have a flawless track record of portending downside to come for the Dow, S&P 500, and Nasdaq Composite. 

Image source: Getty Images.

Time and perspective can change everything on Wall Street

On one hand, the prospect of significant downside in the stock market might sound scary — especially for newer investors who haven’t weathered a true pullback in equities before.

On the other hand, investor perspective can change everything.

For instance, every year, Crestmont Research updates an extensive data set that calculates the rolling 20-year total returns (including dividends) of the benchmark S&P 500 dating back to the start of the 20th century. The S&P dates from 1923, but researchers were able to track the performance of its components in other major indexes back to 1900. This yielded 106 rolling 20-year periods with ending years ranging from 1919 through 2024.

What Crestmont Research’s data set showed is that all 106 rolling 20-year periods produced a positive total return. An investor who purchased an index fund that mirrored the performance of the S&P 500 at any point since 1900 and simply held on to that position for 20 years would have made money 100% of the time.

A separate analysis from Bespoke Investment Group also demonstrates the power of perspective on Wall Street.

In June 2023, shortly after the S&P 500 was confirmed to be in a new bull market, Bespoke published a data set on X that compared the length of every bull and bear market for the broad-based index dating back to the start of the Great Depression. This roughly 94-year span featured 27 separate bull and bear markets.

Based on Bespoke’s calculations, the average bear market endured for only 286 calendar days, which works out to around 9.5 months. What’s more, the lengthiest bear market drawdown lasted 630 calendar days in the mid-1970s.

The typical S&P 500 bull market stuck around for 1,011 calendar days (roughly two years and nine months). If the current bull market were extrapolated from the publishing of Bespoke’s data set, just over half (14 out of 27) of all bull markets have lasted longer than the lengthiest bear market.

Regardless of what any forecasting or valuation tool suggests will happen to stocks in the short run, time and perspective have a flawless track record of predicting long-term upside in the Dow Jones, S&P 500, and Nasdaq Composite.