Title: The Equity Market's Suspect Progression Might Warn of Challenges Ahead for Main Street's Financial Core
Swinging into 2023, Wall Street has been on a rollercoaster ride reminiscent of a banana year. While traditional averages of 10% yearly gains may be common historical territory, the ageless Dow Jones Industrial Average (DJI), the S&P 500, and the tech-drive Nasdaq Composite have surpassed themselves, registering gains of 17%, 28%, and 33% respectively, up until December 11th.
Wall Street's ebullient performance can be attributed to a multitude of factors. Among these include the burgeoning influence of artificial intelligence (AI), exceeding corporate earnings, the frenzy of stock splits, and the waves created by Donald Trump's election to a non-consecutive second presidency. All these elements contributed to the soaring indices during his first term.
However, when Wall Street seems too good to be true, more often than not, it turns out to be.
Breaking New Records on Wall Street
Before delving deeper into this discussion, a disclaimer: there isn't any forecasting tool, data point, or metric with the power to guarantee a short-term directional move in the Dow, S&P 500, or Nasdaq Composite with 100% accuracy.
Even so, select events, predictive tools, and metrics have demonstrated a strong correlation with moves higher or lower in these major stock indexes throughout history. This combination may entice investors to use these correlative indicators in an attempt to gain an edge, thus anticipating a sizable move in the indexes.
For over a year, some of these predictive tools have sounded alarms, warning of potential perils on Wall Street. For instance, the U.S. M2 money supply recorded its first significant year-over-year decline since the Great Depression in 2023. Additionally, the yield curve is currently experiencing its longest inversion on record. While a yield curve inversion doesn't invariably lead to recessions, every U.S. recession since World War II has been preceded by an inversion.
Lately, a new concern has cropped up that seems to foreshadow trouble for Wall Street: the S&P 500's price-to-sales (P/S) ratio.
The P/S ratio is just one of several building blocks investors can use quickly to assess whether a stock (or an index) is relatively cheap or pricey in comparison to its peers or the broader market. Determined by dividing a company's share price by its trailing-12-month revenue, a lower number generally indicates a more attractive valuation.
As of December 11th, the S&P 500's P/S ratio reached an unprecedented all-time high of 3.18 based on data from Standard & Poor's. Since the turn of the millennium, the average P/S ratio of the broad-based S&P 500 stands at just 1.75.
The record-breaking P/S ratio isn't a timing tool, but bull market rallies where this ratio has surpassed 2.25 since 1990 have, eventually, given room to a sizable move lower in stocks.
Multiple Warning Signals on the Street
The S&P 500's P/S ratio hitting an all-time high isn't the only red flag nowadays. Another valuation metric is also loudly sounding warnings: the S&P 500's Shiller price-to-earnings (P/E) ratio, commonly known as the cyclically adjusted P/E ratio (CAPE ratio).
Investors sometimes rely on the P/E ratio to capture a quick glimpse of whether a stock is pricy or cheap. The P/E ratio entails dividing a company's share price by its trailing-12-month earnings per share (EPS). In contrast, the Shiller P/E is derived from the average inflation-adjusted EPS over the previous 10 years. Accounting for a decade's worth of inflation-adjusted EPS history smooths out shock events, such as pandemic-lockdowns, which can make traditional P/E ratios ineffective for a certain period.
As of Dec 11, the Shiller P/E closed at 38.86, being well over twice the average reading of 17.17 dating back to January 1871. This makes it the third-highest reading during a bull market rally in more than 150 years. Only five occasions in the past 150 years have seen the S&P 500's Shiller P/E surpass 30, including the present. Previous occurrences were eventually followed by losses in the S&P 500 or Dow Jones Industrial Average ranging from 20% to 89%. It's clear that premium valuations aren't tolerated for extended periods in Wall Street.
The S&P 500's price-to-book ratio also scaled new heights, standing at an all-time high. Additionally, Warren Buffett's favorite measure of value, the "Buffett Indicator," which divides the market cap of all stocks by U.S. gross domestic product (GDP), is at 208%. This index has averaged 85% since 1970.
Given what history suggests, troubles could lie ahead for Wall Street.
A Silver Lining for Patient Investors
Although multiple valuation markers are pointing to a high likelihood of volatility and potential downturns, history offers a silver lining for investors endowed with patience and a level head.
Regardless of the actions taken by the government or central bank, it's impossible to prevent stock market downturns from ultimately materializing. However, the beauty of perspectives is the ability to step back, observe the nonlinear relationship between bear and bull market cycles, and understand that.
Data published on social media platform X in June 2023 by researchers at Bespoke Investment Group showed the average duration of every bear and bull market in the S&P 500 dating back to the start of the Great Depression in September 1929.
Of the 27 S&P 500 bear markets scrutinized, the longest lasted 630 calendar days, and the average decline span 286 calendar days (around 9.5 months). Conversely, the 27 S&P 500 bull markets endured for an average of 1,011 calendar days. Over half (14 out of 27, including the current bull market) surpassed the longest bear market.
No matter which metric or predictive tool you choose, you'll never foresee the precise timing of a stock market correction, bear market's commencement, or the depth of declines beforehand. But what trends unambiguously emerge is that patience prevails. Every downturn in the Dow, S&P 500, and Nasdaq Composite has eventually been surpassed by a bull market rally in the past.
Even a stock market considered one of the priciest on record can't deter the patience and perspectives of investors.
Given the record-breaking P/S ratio of the S&P 500, some investors might consider diversifying their portfolios and exploring other investment opportunities, such as real estate or bonds, to mitigate potential risks.
Furthermore, considering the current record-breaking stock prices and high valuation ratios, it might be an opportune time for those with a long-term investment horizon to consider investing in undervalued stocks or sectors, as they may provide attractive returns in the future.
