One of Wall Street's Most Unbreakable Records, Spanning 155 Years, Is on the Verge of Toppling -- and It Has Terrifying Implications for the Stock Market
Written by Sean Williams for The Motley Fool->
Artificial intelligence euphoria, among other factors, has lifted the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite to new heights.
Earlier this month, the stock market came within a stone's throw of its priciest valuation since January 1871.
Although premium valuations historically foreshadow trouble for Wall Street, history has a way of rewarding optimistic, long-term investors.
Despite a short-lived swoon in March, the stock market is delivering another banner year for investors. During the first week of June, the timeless Dow Jones Industrial Average (DJINDICES: ^DJI), broad-based S&P 500 (SNPINDEX: ^GSPC), and innovation-driven Nasdaq Composite (NASDAQINDEX: ^IXIC) all reached fresh record-closing highs.
Catalysts have been plentiful for investors, with the stock market's historic rally driven by:
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However, even the most powerful bull markets have their limits. One of Wall Street's perceived-to-be unbreakable records is currently within eyeshot of being toppled. Should this historic event take place, it would have terrifying implications for the stock market.
To preface the following discussion, the past can't concretely guarantee the future. Nevertheless, history has a way of rhyming on Wall Street, making the past an excellent teacher and/or predictor of the future, more often than not.
In addition to the AI revolution sparking investor excitement and driving up long-term growth projections, this game-changing innovation has spearheaded a historic expansion of valuation multiples on Wall Street.
The most time-tested of all valuation tools is the price-to-earnings (P/E) ratio, which is calculated by dividing a company's share price by its trailing 12-month earnings per share (EPS). The traditional P/E ratio is a fantastic tool for quickly evaluating mature businesses -- but it's not perfect. Since the P/E ratio only accounts for 12 months of EPS history, recessions that turn profits into losses can render this valuation tool useless.
This is where the S&P 500's Shiller P/E Ratio separates itself. The Shiller P/E, also known as the Cyclically Adjusted P/E Ratio (CAPE Ratio), is based on average inflation-adjusted EPS over the trailing decade. Accounting for 10 years of EPS history ensures that the Shiller P/E remains useful at all times and can provide apples-to-apples valuation comparisons of the S&P 500 throughout history.
Though economists only introduced the CAPE Ratio in the late 1980s, it's been back-tested to January 1871, providing 155 years of historical valuation data. Over these 155 years, it's averaged a multiple of approximately 17.4.
Shiller PE Ratio is now just 3.5% away from passing the Dot Com Bubble as the most expensive stock market valuation in history 🚨🚨🚨 pic.twitter.com/1ceOa3yhfs
During the internet boom of the late 1990s, the S&P 500's Shiller P/E vaulted to its all-time high of 44.19. To put this figure into perspective, the Shiller P/E had only previously topped 30 one other time between January 1871 and the late 1990s (just before the Great Depression). The dot-com bubble valuation peak was over 45% higher than the pre-Great Depression valuation top. This appeared to be an unbreakable valuation multiple... until now.
Earlier this month, when the Dow, S&P 500, and Nasdaq Composite rallied to new highs, the S&P 500's CAPE Ratio hit its second-highest level during a continuous bull market of 42.84. The stock market is within eyeshot of toppling the dot-com-era valuation premium.
This is noteworthy because Shiller P/E Ratios above 30 have consistently portended trouble for Wall Street. The Shiller P/E has exceeded 30 on six occasions since January 1871. Excluding the present, the previous five occurrences were all eventually followed by declines in the Dow Jones Industrial Average, S&P 500, and/or Nasdaq Composite of 20% to 89%.
The only two previous times the CAPE Ratio topped 40 saw the S&P 500 and Nasdaq Composite lose 49% and 78% of their respective value (dot-com bubble), and roughly a quarter and a third of their value (2022 bear market).
Premium valuations aren't well tolerated on Wall Street, meaning the current bull market is likely running on borrowed time.
Even if the dot-com-era valuation record holds firm, history is quite clear that repercussions are expected. At the very least, historical precedent would call for a modest bear market.
Although most investors aren't fans of seeing red arrows in their portfolio, stock market corrections, bear markets, and even the occasional emotion-driven crash are par for the course when putting your money to work in the greatest wealth-creating machine. No fiscal or monetary policies can stop occasional stock market downturns.
But here's the truly great thing about history: it works in both directions and undeniably favors the patient.
Four weeks ago, analysts at Bespoke Investment Group published a data set on social media platform X that examined the calendar length of every S&P 500 bull and bear market since the start of the Great Depression in September 1929. What Bespoke's data set highlights is the night-and-day disparity between optimism and pessimism on Wall Street.
Of the 27 S&P 500 bear markets since September 1929, none have lasted longer than 630 calendar days. More importantly, the average bear market reached its trough after just 286 calendar days (about 9.5 months).
The current bull market that began on 10/12/22 is now the 9th longest in S&P 500 history, surpassing the 1,324-day bull that ended on 2/9/1966: pic.twitter.com/4mGsS2t2ft
On the other hand, the typical S&P 500 bull market has persisted for 1,023 calendar days over the last 97 years. Bespoke's data set also shows that just over half (14) of these bull markets have lasted longer than the aforementioned lengthiest bear market.
The analysts at Crestmont Research widened their lenses even further by calculating the rolling 20-year total returns (including dividends) of the S&P 500 since 1900. Given that the S&P wasn't incepted until 1923, researchers had to track the total returns of its components in other major indexes back to the start of the 20th century.
What Crestmont uncovered was an eye-opener for long-term investors. Of the 107 rolling 20-year periods examined, all 107 produced a positive annualized return. In other words, if an investor had, hypothetically, purchased an S&P 500-tracking index at any point between 1900 and 2006 and simply held it for 20 years, they would have generated a profit every time. Regardless of how many variables were stacked against the stock market, time proved to be the greatest ally for investors.
If history rhymes, yet again, and the stock market tumbles from a historically pricey valuation multiple, it'll serve as an opportunity for long-term-minded investors to pounce.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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