For over a century and a half, historical valuation data has provided a solid foundation for estimating where the major indexes on Wall Street might eventually hit rock bottom.
Recently, the journey for investors on Wall Street has been anything but smooth. In the past seven weeks, we’ve been given a reminder that reaching investment goals isn’t typically a straightforward path. Between February 19, when the S&P 500 reached its peak, and April 4, the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite have dropped 14.2%, 17.4%, and 22.3% respectively. This dip placed the Dow and the S&P 500 in what we call correction territory, while the Nasdaq has sunk into a bear market.
When stock valuations take significant hits, emotions tend to drive reactions. So naturally, everyone’s wondering: how much further could the Dow, S&P 500, and Nasdaq fall before they find stability?
While predicting market movements with absolute certainty is beyond our capabilities, there’s a historically reliable valuation indicator that offers substantial insight into where Wall Street’s primary indexes might land.
For the time being, the spotlight is on President Trump’s tariff strategy. On what he dubbed “Liberation Day,” April 2, Trump announced sweeping global tariffs of 10% and other reciprocal tariffs targeted at countries with which the U.S. has had trade imbalances.
This has stirred a fair share of concerns among investors. The fear is that these tariffs might drive up inflation rates, strain trade relationships with key global partners, or even trigger a recession in the U.S.
Adding fuel to the fire, research from four economists at the New York Fed on Liberty Street Economics identified negative links between publicly traded companies affected by Trump’s tariffs on China in 2018-2019 and their stock performance on tariff announcement days.
Amidst the tariff turmoil, the Shiller price-to-earnings (P/E) Ratio emerges as a key indicator in forecasting where the Dow, S&P 500, and Nasdaq may bottom out during this pronounced sell-off.
Known as the cyclically adjusted P/E Ratio (CAPE Ratio), the Shiller P/E is grounded on the average inflation-adjusted earnings over the past decade. This adjustment for inflation and use of a decade’s worth of data helps smooth out the impact of short-term disturbances.
In December, the Shiller P/E Ratio of the S&P 500 hit a bull market cycle peak of 38.89. For context, the historical average Shiller P/E over the past 154 years is 17.23, highlighting just how overvalued the current market is.
In fact, since January 1871, the Shiller P/E has only surpassed 30 and stayed there for at least two months during a bull market on six occasions, including the present. All five previous times ended with a 20% or greater decline for the Dow, S&P 500, or Nasdaq.
Typically, over the last 30 years, the Shiller P/E has found its lowest point around 22. Although it may not always settle precisely at this figure, it has served as a valuation middle ground to which overvalued markets tend to return.
After the market’s steep decline to close the prior week, the S&P 500’s Shiller P/E stands at 31.31 as of April 4, inching near a 20% drop from its recent high, concurrently with a 17% dip in the S&P 500 itself. Should this trend of Shiller P/E multiple corrections and S&P 500 declines continue aligning, a trough at Shiller P/E of 22 might suggest a roughly 39% drop from the S&P 500’s all-time peak, setting its bottom around 3,750.
And what about the Dow and Nasdaq? Given the Dow comprises more mature firms, its decline is projected to be around 30%. Conversely, the highly variable nature of the Nasdaq suggests it might face declines approaching 50% from peak to trough.
Naturally, none of this is set in stone, but this is what one of Wall Street’s most reliable valuation tools is forecasting.
The potential notion that the Dow, S&P 500, and Nasdaq might be only partway (or not even halfway) to their troughs can be disconcerting, especially for newcomers to bear market declines. However, it’s essential to remember that market corrections, bear markets, and volatile periods are standard parts of the investment journey.
Firstly, downturns are healthy and expected. Based on data from Yardeni Research, the S&P 500 has seen 40 corrections since 1950. This means, historically, there’s a double-digit drop in Wall Street’s benchmark every 1.9 years on average. So, long-term investors should expect to ride through several of these market undulations.
More crucially, throughout history, every market correction, bear market, or crash has ultimately been a prime buying opportunity.
Market downturns tend to be brief. Bespoke Investment Group noted on a popular social media platform in June 2023 that the S&P 500’s typical bear market since the Great Depression has averaged about 286 days. This equates to approximately 9.5 months until recovery.
Conversely, Bespoke pointed out that bull markets go on much longer, with the average S&P 500 bull market extending over 1,011 days across 94 years.
Further supporting the importance of time in the market rather than trying to time the market is a study by Crestmont Research.
Crestmont studied 20-year rolling total returns (including dividends) for the S&P 500 dating back to the early 1900s. Despite the S&P 500 not being officially formed until 1923, researchers could track its components within other indices before that year. This research revealed 106 rolling 20-year return periods (1900-1919, 1901-1920, through 2005-2024).
Amazingly, Crestmont Research found that every one of these 106 rolling 20-year periods yielded a positive annualized return. This means that hypothetically, if you had invested in an S&P 500 index tracker anytime from 1900 to 2005 and held your position for two decades, you would have ended up with a profit each time.
In conclusion, every market correction, bear market, and crash serves as a robust buying opportunity for patient investors willing to see the long game.
