I’ve got a mix of news to share with you today, both good and bad, but let’s start on a positive note: The S&P 500 is no longer technically in a “correction” phase.
Just earlier this year, after reaching a record high of 6,144 on February 19, the S&P took a steep dive to close at 5,522 by March 13, a drop of 10.1% from its peak. However, the tides have turned, and as of last Friday’s close, the index dipped by just 7.8%, landing slightly under 5,668. We’re inching out of correction territory and could be poised to climb again—or maybe not.
### The U.S. Stock Market: A brief history of its ups and downs
The story of the S&P 500 dates back to March 1957, although its roots stretch even further. Before the S&P 500, the Standard Statistics Company, which evolved into S&P Global, started tracking the stock performance of 233 U.S. companies as early as 1923. Over nearly a century, the S&P indexes have witnessed at least 15 distinct bear markets where companies’ values plummeted by 20% or more. These weren’t minor hiccups—some were catastrophic, like the great drop of 86% beginning in 1929, or the significant 60% drop in 1937.
There were also milder declines. For instance, in 1956, the stock market saw a decline of just 21.5%, perhaps spurring the inception of the S&P 500 itself. Or take the 1990 downturn, which barely dodged bear market classification, with a decline of 19.9%, depending on decimal fluctuations. On average, though, bear markets have historically inflicted a hefty punch, with average losses exceeding 38% in 100 years.
### Why the recent S&P 500 correction could signal something bigger
That 38% average loss caught my attention recently when I came across a St. Louis Fed report. This report used data from the U.S. Bureau of Economic Analysis to craft a stark illustration of what “normal” corporate profit margins look like Stateside. Historically, from 1936 to 2011, U.S. companies have operated with profit margins ranging between 3.8% and 7.2%.
However, a shift occurred in 2012, and it magnified with COVID-19 in 2020, pushing profit margins beyond traditional levels. This deviation from historical norms is concerning because such drastic increases aren’t typically sustainable. Consider this: Currently, profit margins are averaging 9%. Should they revert to their historical mean of 7.2%, we’re looking at a potential 20% reduction in overall corporate profits.
### What happens if profit margins tighten?
Here’s why I’m concerned that a retreat to normal profit margins could trigger a more profound market downturn: As profit margins shrink and earnings slip, investors’ appetite for paying high multiples on those earnings often diminishes too. This double blow means not only do earnings decline, but the stock prices investors are willing to pay decrease as well.
Imagine a fictional company, “Capitalism ‘R’ Us,” earning $1 per share. At present, investors pay about 28 times earnings for an average S&P stock.
28 x $1 means Capitalism’s stock sits at $28.
But envision a scenario where Capitalism’s profit margin shrinks, earnings fall to $0.80 per share, and investors, spooked, reduce their multiplier to just 21 times earnings.
21 x $0.80 brings the stock down to $16.8.
In the blink of an eye, Capitalism’s stock value drops 40%, aligning closely with the average bear market slide over the last century.
### A silver lining for the hopeful
Unfortunately, it’s not all doom and gloom. Despite 15 crashes in a century, the S&P 500 still manages an average annual growth of 10% to 11% when dividends are accounted for. Historically, there hasn’t been any indication this trend won’t continue, providing a glimmer of hope for long-term investors. We may, however, have to face another hurdle before the growth resumes.
So, how can you brace for the future?
Consider reallocating your portfolio towards individual value stocks you know aren’t overvalued, regardless of the market’s valuation. Stay clear of leverage and debt. Avoid risky investments like meme stocks or cryptocurrencies that lack clear value. When downturns hit, remember you can’t predict their duration, but rest assured, they will eventually end.
Hang tight, stay informed, and keep investing in the right kinds of opportunities.
