One of the S&P 500's Most Flawless Forecasting Tools Is Flashing an Unmistakable Warning for Wall Street

For more than a century, no asset class has been able to hold a candle to the return potential that stocks bring to the table. While bonds, commodities, and real estate have been effective at increasing investors' nominal wealth, Wall Street's major stock indexes -- the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500 (SNPINDEX: ^GSPC), and Nasdaq Composite (NASDAQINDEX: ^IXIC) -- have delivered a higher long-term annualized return.

Though Wall Street's major indexes rising in value over multidecade periods is the norm, getting from Point A to B is rarely, if ever, a straight line. Short-term directional moves in stocks can be influenced by news events and investor emotions, which is what makes forecasting these moves with any accuracy so challenging.

Although no data point or previous event can guarantee short-term directional moves for the Dow, S&P 500, and Nasdaq Composite, certain events have strongly or even flawlessly correlated with significant swings in these indexes throughout history. One such flawless forecasting tool for the S&P 500 is currently flashing an unmistakable warning for Wall Street.

Image source: Getty Images.

This has consistently spelled trouble for the S&P 500 since 1957

At any given moment, there are always one or more headwinds threatening to pull the rug out from beneath Wall Street's benchmark index, the S&P 500. Perhaps the one headwind investors should be paying close attention to is the rise being observed in outstanding margin debt.

In its simplest form, margin is money borrowed from your broker that's used for investment purposes. When short-selling a stock (wagering on its share price to decline), using margin is essentially unavoidable. Since you're borrowing shares that you don't own, there's an annual borrowing rate you, as the short-selling investor, would pay to your broker.

But investors can also use margin to purchase stocks and lever their investments. Similar to short-selling, borrowing money from your broker comes with an obligation to pay interest. This borrowed capital has the potential to amplify your gains if correct, but also magnify your losses if your investment thesis is wrong. In other words, it's risky and exposes investors to the possibility of a margin call, affording your broker the right to sell some/all of your holdings at potentially disadvantageous prices to satisfy your capital needs.

Since the modern S&P 500 index was officially launched in March 1957, parabolic increases in outstanding margin debt have consistently spelled trouble for Wall Street's most encompassing index.

Margin Debt increased +42% in the past 7 months. Investors went all-in.

This only happened 5 times before, and the S&P 500 was lower 1 year later every time.

The last 2 times? February 2000 & May 2007 pic.twitter.com/iO3emr8M0O

-- Subu Trade (@SubuTrade) December 17, 2025

As you can see in the post above on X (formerly Twitter) from data-driven research account SubuTrade, there have only been six instances over the previous 69 years in which margin debt has climbed by at least 42% over a seven-month stretch. Not including the present, the previous five occurrences have seen the S&P 500 lower 100% of the time one year later by an average of nearly 7%.

A dramatic uptick in margin debt usage has commonly preceded stock market tops. This likely has to do with strong gains in the S&P 500 stoking the fear of missing out (FOMO) in investors.

For example, margin debt spiked the month prior to the bursting of the dot-com bubble. The S&P 500 and Nasdaq Composite eventually lost 49% and 78% of their respective value on a peak-to-trough basis. We also witnessed a spike in outstanding margin debt mere months before the financial crisis began taking shape in 2007. The S&P 500 lost 57% of its value during the financial crisis.

While a rapid rise in margin debt doesn't offer any assistance in forecasting the magnitude or length of a forthcoming stock market decline, it does have, thus far, a flawless track record of predicting short-term directional moves lower in the benchmark S&P 500.

Image source: Getty Images.

Wall Street's bull market may be running on borrowed time

What's worrisome for investors is that margin debt isn't the only historically perfect correlation that points to the possibility of significant downside in the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.

For example, the valuation of equities is undeniably worrisome. Even though valuations are subjective (i.e., what you find to be expensive might be viewed as a bargain by another investor), one time-tested valuation tool has a knack for cutting through emotions and subjectivity: 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.

What sets the Shiller P/E apart is that it's based on average inflation-adjusted earnings from the previous 10 years. Whereas recessions can turn earnings per share (EPS) negative, rendering the traditional P/E ratio useless, the CAPE Ratio's incorporation of a decade's worth of EPS history maintains its usefulness in any climate.

When back-tested to 1871, the Shiller P/E has averaged approximately 17.3. But as of the closing bell on Jan. 22, 2026, it was tipping the scales at a multiple of 40.63. The stock market entered 2026 at its second priciest valuation in history, trailing only the dot-com bubble.

S&P 500 Shiller PE Ratio hits 2nd highest level in history 🚨 The highest was the Dot Com Bubble 🤯 pic.twitter.com/Lx634H7xKa

-- Barchart (@Barchart) December 28, 2025

Similar to the correlation between margin debt and stock market performance, the Shiller P/E doesn't offer any help in determining when the music might stop on Wall Street. Nevertheless, CAPE Ratios above 30 have historically foreshadowed significant declines to come.

Over the last 155 years, the Shiller P/E has surpassed 30 and held this mark for at least two months on six occasions, including the present. The prior five occurrences were all subsequently followed by declines in the Dow Jones Industrial Average, S&P 500, and/or Nasdaq Composite, ranging from 20% to 89%. While a Great Depression-esque drawdown of 89% in the Dow is highly unlikely in modern times, a minimum retracement of 20%, if not more, should be expected.

Although this bull market may be running on borrowed time, it's equally important to recognize that perspective changes everything. While the short term can be volatile and unpredictable, stocks are, at the end of the day, the greatest long-term wealth creator. If margin debt and the Shiller P/E accurately forecast a meaningful pullback in equities, it would likely be an opportune time for long-term investors to pounce.

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.