The Stock Market Is Making Dubious History, and It Appears to Foreshadow Trouble for Wall Street

This has been nothing short of a banner year for Wall Street. Whereas the stock market has historically delivered average annual gains of around 10%, the ageless Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and growth stock-dominated Nasdaq Composite (NASDAQINDEX: ^IXIC) have catapulted higher by 17%, 28%, and 33% on a year-to-date basis, as of Dec. 11.

The stock market has benefited from a confluence of factors that include the rise of artificial intelligence (AI), better-than-anticipated corporate earnings, stock-split euphoria, and excitement following the election of Donald Trump as president for a nonconsecutive second term. The Dow Jones, S&P 500, and Nasdaq Composite all soared during Trump's first term in office.

But when things seem too good to be true on Wall Street, more often than not, they usually are.

Image source: Getty Images.

The stock market is making history in more ways than one

Before going any further, let me preface the following discussion by noting there is no forecasting tool or data point that can, with 100% accuracy, guarantee a short-term directional move in the Dow, S&P 500, or Nasdaq Composite.

There are, however, select events, predictive tools, and metrics that have strongly correlated with moves higher or lower in Wall Street's major stock indexes throughout history. Investors will occasionally lean on these correlative indicators in an attempt to gain an edge and front-run a sizable move in the major indexes.

For more than a year, some of these predictive tools have warned of potential trouble on Wall Street. For instance, U.S. M2 money supply endured its first sizable year-over-year decline in 2023 since the Great Depression. Further, the yield curve is navigating its longest inversion on record. While not all yield-curve inversions are followed by recessions, every U.S. recession following World War II has been preceded by an inversion.

In recent weeks, a new concern has taken shape that appears to foreshadow trouble for Wall Street: the S&P 500's price-to-sales (P/S) ratio.

The P/S ratio is one of a handful of building blocks investors can quickly use to assess whether a stock (or an index) is relatively cheap or pricey to its peers or the broader market. Dividing a company's share price into its trailing-12-month revenue yields the P/S ratio, with a lower number traditionally being better (i.e., a more attractive valuation).

As of the closing bell on Dec. 11, the S&P 500's price-to-sales ratio rose to an all-time record of 3.18, based on data from Standard & Poor's. Since the end of 2000, the average P/S ratio of the broad-based S&P 500 is just 1.75.

The previous high for the S&P 500's P/S ratio was 3.04 in December 2021, which was eventually followed by the 2022 bear market. The Dow, S&P 500, and Nasdaq Composite all lost in excess of 20% on a peak-to-trough basis in 2022.

While the S&P 500's P/S ratio isn't a timing tool -- i.e., stocks can remain pricey for weeks, months, or even years -- bull market rallies where this ratio has surpassed 2.25 since 1990 have, eventually, given way to a sizable move lower in stocks.

Multiple valuation tools are sounding warnings on Wall Street

However, the S&P 500's P/S ratio hitting an all-time high is far from the only valuation metric making dubious history at the moment.

The S&P 500's Shiller price-to-earnings (P/E) Ratio, which is commonly referred to as the cyclically adjusted P/E Ratio, or CAPE ratio, is also nearing uncharted territory, when back-tested 153 years.

S&P 500 Shiller CAPE Ratio data by YCharts.

Traditionally, investors rely on the P/E ratio if they want a quick picture of whether a stock is pricey or cheap. The P/E ratio divides a company's share price into its trailing-12-month earnings per share (EPS).

By comparison, the Shiller P/E is based on average inflation-adjusted EPS over the last 10 years. Accounting for 10 years' worth of inflation-adjusted EPS history smooths out the shock events (e.g., lockdowns during the COVID-19 pandemic) that can make the traditional P/E ratio virtually useless for a period.

On Dec. 11, the Shiller P/E closed at 38.86, which is well over double the average reading of 17.17 dating back to January 1871. It's also the third-highest reading during a bull market rally over this 153-year stretch.

There have only been six instances in more than 150 years when the S&P 500's Shiller P/E surpassed 30, including the present. The prior five occurrences were all, eventually, followed by losses in the S&P 500 or Dow Jones Industrial Average ranging from 20% to 89%. It clearly shows that premium valuations aren't tolerated for extended periods on Wall Street.

To add fuel to the fire, the S&P 500's price-to-book ratio is also at an all-time high, and Warren Buffett's once-touted favorite measure of value, which divides the market cap of all stocks into U.S. gross domestic product, is at 208%. This "Buffett Indicator" has averaged closer to 85% since 1970.

Based on what history tells us from prior incidences of stock valuations becoming overly extended to the upside, trouble lies ahead for Wall Street.

Image source: Getty Images.

History also offers a silver lining for investors

Although multiple valuation measures are portending a high likelihood of volatility and potential downside for the stock market, history also provides a silver lining for investors who exercise patience and maintain perspective.

As much as investors might dislike stock market corrections and bear markets, they're a normal and inevitable aspect of the investing cycle. Regardless of the fiscal and monetary actions respectively taken by the federal government and nation's central bank, there's no way to prevent stock market downdrafts from eventually taking shape.

But the great thing about perspective is the ability to take a step back and observe the nonlinearity between bear and bull market cycles.

It's official. A new bull market is confirmed.

The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.

Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp

-- Bespoke (@bespokeinvest) June 8, 2023

This data set was posted on social media platform X in June 2023 by researchers at Bespoke Investment Group. What it shows is the average calendar-day length of every bear and bull market in the benchmark S&P 500 dating back to the start of the Great Depression in September 1929.

Of the 27 S&P 500 bear markets examined, the longest endured for 630 calendar days, with the average decline lasting 286 calendar days (roughly 9.5 months). Comparatively, the 27 S&P 500 bull markets stuck around for an average of 1,011 calendar days, and more than half (14 out of 27, including the current bull market) were lengthier than the longest bear market.

No matter which metrics or predictive tools we rely on, we're never going to be able to accurately predict ahead of time when a correction or bear market will start, how long it'll last, or how steep the ultimate decline will be. But what we do know is that patience prevails. Eventually, every downturn in the Dow, S&P 500, and Nasdaq Composite has been brushed aside by a bull market rally.

Even one of the priciest stocks markets on record is no match for what patience and perspective have done for investors.

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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.