Whether you’ve been putting your money to work on Wall Street for decades or are a relatively new investor, the past couple of months have been challenging. Since the first week of January, the benchmark S&P 500 (^GSPC -2.81%) and widely followed Dow Jones Industrial Average (^DJI 0.00%) hit correction territory with declines of at least 10%. Meanwhile, the growth-focused Nasdaq Composite (^IXIC 0.00%) briefly entered a bear market with a peak decline of 22% between mid-November and mid-March.
But based on two key figures, all three major U.S. indexes could have a lot further to fall.
1. The S&P 500 Shiller P/E ratio portends trouble
The first figure of interest is the S&P 500’s Shiller price-to-earnings (P/E) ratio, which is also known as the cyclically adjusted P/E ratio, or CAPE ratio. The Shiller P/E takes into account average inflation-adjusted earnings over the past 10 years. It closed at 33.63 last weekend and was north of 40 in early January.
Over the past quarter of a century, the S&P 500’s Shiller P/E has been elevated well above historic norms (the average S&P 500 Shiller P/E since 1870 is 16.94). I’d attribute this to the internet democratizing the dissemination of information to Main Street. With income statements, balance sheets, and news available at the click of a button, it’s been easier for investors to support loftier valuations.
However, history hasn’t been all that kind to investors whenever the S&P 500’s Shiller P/E ratio has crossed above 30 and sustained that level for any length of time. There are only five instances in the past 151 years where the S&P 500’s Shiller P/E crossed above 30, including right now. In the four previous instances, the S&P 500 went on to lose at least 20% of its value. During the Great Depression, the U.S. stock market lost nearly 90% of its value, peak to trough.
While a 90% decline is highly unlikely today due to various fiscal and monetary tools that can be used to support or stabilize equities, the historic base expectation when valuations get stretched, as they are now, is a 20% decline for the S&P 500.
2. A historic surge in margin debt suggests a stock market crash is likely
The second figure that portends a stock market crash is outstanding margin debt. Margin is the amount of money borrowed with interest by investors to purchase or bet against securities.
In some instances, such as short-selling shares of a publicly traded company, margin is a requirement. More often than not, though, margin is a pathway to trouble. Although it can pump up your gains if a stock moves the direction you expect it to, it can also magnify your losses if things don’t go as planned.
Over the very long term, we would expect to see the amount of outstanding margin debt slowly but steadily increase as the overall value of publicly traded stocks rises. But in those few instances where margin debt usage spiked higher, trouble has always followed.
Since the beginning of 1995, there have been three instances where margin debt outstanding climbed by at least 60% from the previous year. It occurred in 1999, directly before the dot-com bubble that wiped out nearly half of the S&P 500’s value. It also occurred in 2007, just before the financial crisis ultimately reduced the value of the S&P 500 by 57%.
Last year, it happened for a third time, with outstanding margin debt rising by close to 70%. Since then, the S&P 500 has responded by pushing into correction territory. If history repeats once again, the S&P 500 still has a ways to fall.
Stock market crash or not, here’s why you shouldn’t worry
While there’s no question that the velocity of downside moves in the stock market can be scary, there are a number of reasons for investors not to be worried about near-term volatility or the possibility of a crash.
Last month, I attempted to answer the unanswerable: How long do stock market corrections last? Although we’ll never know ahead of time when a crash or correction will begin, what’ll cause it, or how steep the decline will be, history is pretty clear that most stock market corrections occur over short periods.
Not including the current correction, which began in January, the 38 previous double-digit declines in the S&P 500 since the beginning of 1950 have lasted an average of 188.6 days (about six months). Interestingly, since computers became mainstream on Wall Street’s trading floor in the mid-1980s, the average peak-to-trough correction has taken only 155.4 days (about five months). In other words, the modern-day market that allows investors to access information easily has resulted in shorter corrections.
In total, 24 of the S&P 500’s 38 corrections found their bottom in 104 calendar days (3.5 months) or less. Comparatively, only seven times in the past 72 years has a correction lasted longer than a year. In fact, over the past 40 years, it’s only happened twice (the dot-com bubble, 2000-2002, and the financial crisis, 2007-2009).
In addition to corrections resolving quickly, the stock market has proven undefeated as a wealth-building tool over the long run.
Every year, Crestmont Research publishes data on the rolling 20-year total returns for the S&P 500 between 1919 and the previous year (in this case, 2021). Effectively, this data shows the annual total return, including dividends, for the S&P 500 over any rolling 20-year period spanning 103 end years.
As an example, if 1974 were arbitrarily chosen as the end year, the average annual total return for the S&P 500 would take into account the years 1955 through 1974. No matter which of the 103 end years you choose, the S&P 500 has delivered a positive total return in every single one of them over a 20-year period. Put another way, if you bought an S&P 500 tracking index at any point between 1900 and 2002 and held for 20 years, you made money.
What’s more, you probably made a lot of money. Only two of the 103 end years since 1919 (1948 and 1949) have averaged rolling 20-year annual total returns of less than 5%. By comparison, over 40 of the 103 end years have produced an average annual total return of at least 10%.
Since all stock market corrections, bear markets, and crashes are eventually erased by bull market rallies, this data is telling you that if you buy high-quality companies during pullbacks and hang onto them for long periods of time, you have a very high probability of increasing your wealth.
Stock market crash or not, patient investors have no reason to be worried.