The Stock Market Just Breached a Never-Before-Seen Threshold — and History Couldn’t Be Clearer About What Happens Next

By Investor Empires On Nov 30, 2024

It’s been an exceptional year for investors. Since hitting bottom in October 2022, it has become an iconic symbol Dow Jones Industrial Average (DJI: ^DJI)With a wide base Standard & Poor’s 500 (SNPINDEX: ^GSPC)and driven by innovation Nasdaq Composite (NASDAQ: ^IXIC) All rose to multiple record highs.

The epic stock market rally is fueled by a bull run Artificial Intelligence (AI)Follow the excitement President-elect Donald Trump winsCorporate profit growth exceeds widely agreed expectations.

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While nothing seems to stand in the way of these three triggers, history is not so forgiving.

Image source: Getty Images.

Over the past year, there has been no shortage of economic data points or forecasting tools warning of potential problems for the US economy and/or Wall Street. Examples include the first significant decline in the US money supply since the Great Depression, the longest yield curve inversion ever, and the record high of the Buffett Index. However, there’s a new concern to add to the list: the S&P 500’s price-to-book ratio.

For individual companies, their book value actually shows what shareholders would receive if, hypothetically, the company were liquidated (i.e. its assets minus liabilities). While book value is not the fundamental, inevitable metric it once was, it still serves an important function in helping value investors identify undervalued stocks.

However, book value is not just a measure used for individual companies. We can examine the collective book value of companies that make up key indicators to determine whether the components, as a whole, are cheap or expensive collectively.

Over the past 25 years, the average price-to-book value of the S&P 500 has been 2.83, which is neither particularly low, nor is it egregiously high. As the Internet democratized access to information in the mid-1990s and interest rates declined in the wake of the financial crisis, investors were encouraged to take more risk and invest in growth stocks, which were expected to lead to higher price-to-book ratios.

But there is an undeniable line that the S&P 500 has crossed recently (key word!) It led to trouble every time.

Price to book ratio chart for the S&P 500 — Standard & Poor’s 500 Price to Book Ratio Data by YCharts. Readings are tabulated quarterly, with the latest reading (4.793) for the chart above being as of September 30, 2024.

Before 2024, there were only two instances in a quarter-century when the S&P 500’s price-to-book ratio exceeded 4 during a bull market rally:

As of the closing bell on November 26, 2024, the S&P 500’s price-to-book ratio was at an all-time high of 5.30.

After the fourth quarter of 2021, the Dow Jones, S&P 500 and Nasdaq Composite indexes entered a bear market, with the S&P 500 losing about a quarter of its value. Meanwhile, the broad index lost 49% of its value when the dot-com bubble burst, with the Nasdaq Composite losing 78% on a peak-to-trough basis.

History is quite clear that once the S&P 500’s price-to-book ratio extends, it’s only a matter of time before a major correction occurs.

However, the S&P 500’s breach of its unprecedented price-to-book threshold isn’t the only valuation metric raising eyebrows on Wall Street.

Most investors are probably familiar with the traditional price-to-earnings (P/E) ratio as a way to make quick assessments of whether or not a stock is inexpensive or expensive. The P/E ratio divides a company’s stock price (or index) into its trailing 12-month earnings per share (EPS) to make this evaluation.

A potential problem with the traditional P/E ratio is that shock events render it useless. For example, early-stage lockdowns during the coronavirus (COVID-19) pandemic short-lived corporate earnings and skewed trailing-12-month EPS for most public companies.

S&P 500 Shiller CAPE ratio chart — The Cape Shiller ratio for the S&P 500 index Data by YCharts.

Arguably the most complete measure of value is the S&P 500’s P/E ratio, also referred to as the cyclically adjusted P/E ratio (CAPE ratio). Shiller’s P/E multiple is based on average inflation-adjusted EPS from the previous 10 years, which means it is able to smooth out the lumpiness associated with short-term shock events.

When tested back to 1871, Shiller’s average P/E reached a rather modest reading of 17.17. But you’ll notice that this percentage has spent most of the last 30 years above the 153-year average, which again is a reflection of the democratization of information, easier access to online trading/investing, and lower prevailing interest rates. Rates.

But when the closing bell rang on November 26, Shiller’s P/E reached 38.41, its highest reading during the current bull market rally as well as the third-highest reading during a sustained bull market over the past 153 years. The only two times the S&P 500’s P/E ratio rose were (drum roll) before the dot-com bubble burst when it reached an all-time high of 44.19, and just before the bear market in 2022 when it briefly exceeded. 40.

Since January 1871, there have been only six instances, including the current one, when the S&P 500 P/E has exceeded the 30 level. After each of the previous five events, the benchmark index and/or the Dow Jones Industrial Average fell by between 20% and 89% of its value.

Value may be in the eye of the beholder, but history couldn’t be clearer that trouble is brewing in the stock market.

A person holds a tablet in his left hand while critically reading a financial newspaper in his right hand. — Image source: Getty Images.

While the near-term outlook for the Dow Jones, S&P 500 and Nasdaq Composite looks risky, at best, based on two historically flawless valuation metrics, it’s a very different story if investors rely on history and widen their lenses.

A perfect example of time working for investors can be seen in the analysis conducted by Crestmont Research which is updated on an annual basis.

Researchers at Crestmont examined the 20-year rolling total returns, including dividends paid, of the S&P 500 index dating back to 1900. Although the S&P index did not exist until 1923, researchers were able to track the performance of its components in indexes Others date back to the beginning of the twentieth century. The ability to backtest to 1900 resulted in 105 20-year rolling periods, with expiration dates ranging from 1919 to 2023.

What Crestmont’s analysis showed was that all 105 of the 20-year timelines produced a positive total return for investors. In other words, if an investor had, in theory, bought an index fund that mirrored the performance of the S&P 500 at any time since 1900 and held that position for 20 years, his initial investment would have grown.

Moreover, the Crestmont data set shows that long-term investors have had little gain. The average annual total return for 50 of these 105 20-year periods exceeded 9%, which would double an investor’s money on an annual compounding basis every eight years.

Even as the stock market breaches unprecedented valuation thresholds, it’s still there To the fullest extent There is every possibility that the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite will rise significantly twenty years from now.

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Sean Williams He 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 Disclosure policy.

The stock market has just crossed an unprecedented threshold — and history couldn’t be clearer about what will happen next Originally published by The Motley Fool