As of March 20, the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite have all experienced notable declines since February 19, shedding 6%, 7.8%, and 11.8% of their values, respectively. While the S&P 500 and Nasdaq have entered correction territory, neither index has dropped below their March 13 closing lows. This raises a crucial question: Has the stock market correction ended, or is Wall Street bracing for a deeper decline? To shed light on this, we turn to a forecasting tool with over 150 years of data—the Shiller Price-to-Earnings (P/E) ratio.
Wall Street’s Stock Market Correction: Is It Over?
The current market correction has caught the attention of investors, as major stock indexes like the Dow Jones, S&P 500, and Nasdaq Composite have seen significant losses since February. But the critical question on Wall Street is whether the correction has already ended or if more pain is in store.
One key indicator that has a long track record of predicting market movements is the Shiller P/E ratio. This tool, which measures the cyclically adjusted price-to-earnings ratio (CAPE), uses data from the past 10 years to smooth out short-term market fluctuations. When this ratio crosses the threshold of 30, as it has recently, history suggests a deeper correction is likely.
Shiller P/E Ratio: A Reliable Indicator for Market Predictions
The Shiller P/E ratio provides investors with a more stable long-term view of market valuations compared to the traditional P/E ratio. It adjusts earnings for inflation and averages them over the past 10 years, making it less sensitive to short-term market fluctuations.
As of March 20, the Shiller P/E for the S&P 500 stood at 35.38, well above its historical average of 17.22, which dates back to 1871. This high level is not unusual; in fact, it marks the sixth time in the past 154 years that the ratio has surpassed 30.
Historically, when the Shiller P/E ratio has been above 30 for extended periods, significant declines in the major indexes have followed. In the past, these declines have ranged from 20% to 89%. Thus, while the Shiller P/E ratio cannot predict when a market correction will begin or end, it has proven to be a reliable indicator of larger market corrections in the past.
The Bigger Picture: Stock Market Corrections are Part of the Cycle
Stock market corrections, while unsettling, are a normal and unavoidable part of the investment cycle. According to Yardeni Research, there have been 40 double-digit corrections in the S&P 500 since 1950. That means, on average, a correction occurs once every 1.88 years.
While these downturns can feel extreme in the moment, it’s important for investors to put them in perspective. The average bear market for the S&P 500 since the Great Depression has lasted just 9.5 months. On the other hand, bull markets tend to last much longer, often lasting several years.
Additionally, data from Crestmont Research shows that every 20-year period in the S&P 500, starting from 1900, has produced positive returns. This reinforces the idea that, despite short-term market volatility, long-term investing in index funds like the S&P 500 has historically been a sound strategy.
What’s Next for Investors?
While the current market correction may not yet be over, history has shown that corrections often present opportunities for long-term investors. The key is to stay calm and view market dips as temporary setbacks in the broader investment cycle.
Investors looking for safe long-term returns may consider the S&P 500 index, which has provided positive returns over extended periods, despite the occasional correction. However, it’s essential to be aware that the market may continue to experience turbulence in the short term.
For those interested in exploring more stock picks, The Motley Fool Stock Advisor team has identified 10 stocks that could potentially provide strong returns. According to their analysis, these stocks are poised for growth, outperforming the market significantly. But for those focusing on the broader market, the S&P 500 remains a reliable choice.
While the S&P 500 and Nasdaq Composite may not have hit new lows yet, the Shiller P/E ratio suggests the stock market correction could continue. Historical data shows that high valuations often lead to more significant downturns. For long-term investors, stock market corrections can be a buying opportunity, with the potential for future growth.
