TheEquity Market Transcended a Barrier it Previously Never Breached, Leaving History with a Distinctive Prediction for the Immediate Future.
Given a period of approximately two years since encountering a bear market bottom, the bulls have steered Wall Street's course. This year, benchmark indices such as the Dow Jones Industrial Average (-0.35%), S&P 500 (-0.30%), and growth stock-focused Nasdaq Composite (-0.25%) have soared to new highs multiple times.
The current positive momentum on Wall Street can be attributed to various factors. These include the advancement of artificial intelligence, stock-split enthusiasm, strong corporate earnings performances, an uptick in share repurchases, and optimism following the election of President-elect Donald Trump.
However, it's crucial to remember that the past has a habit of serving as a reminder that these seemingly invincible trends may not always be unstoppable.
Historical precedents on Wall Street
Since reaching the apex of the 2022 bear market, a few indicators and occurrences have suggested potential difficulty for the U.S. economy or the stock market. These include the longest-lasting yield curve inversion in history, an exceptionally high S&P 500 Shiller price-to-earnings ratio, and the first substantial decrease in the U.S.'s M2 money supply since the Great Depression.
One warning sign that may be particularly attention-grabbing for investors is the long-term valuation metric introduced by the late billionaire Warren Buffett. In an interview with Fortune magazine in 2001, Buffett dubbed the market cap-to-gross domestic product (GDP) ratio as "possibly the best single indicator" of a market's valuation at any given moment. Despite Buffett's later distancing himself from solely relying on this indicator, it's commonly referred to as the "Buffett Indicator" on Wall Street.
The Buffett Indicator calculates a country's collective market value of publicly traded stocks and divides it by its GDP. When the ratio is lower, stocks are seen as being affordably priced. Conversely, if the ratio is high, it suggests that stocks are historically expensive compared to the underlying growth rate of the economy.
The most reliable method to evaluate the value of publicly traded stocks in the U.S. is by examining the Wilshire 5000 Index. Each increment in this index represents a $1 billion increase or decrease in the total market value of U.S. stocks.
Recently, media outlets reported that the Buffett Indicator had hit an unprecedented 200% for the first time ever, surpassing the levels reached during the dot-com bubble and the Great Financial Crisis.
Based on 55 years of Wilshire 5000-to-GDP ratio data (aggregated by Longtermtrends.net), this average is around 85%. In other words, the cumulative value of U.S. stocks has traditionally represented around 85% of U.S. GDP.
However, over the past three decades, this ratio has typically remained above this mean. In fact, since 1998, the ratio has predominantly surpassed this typical valuation tag. Although a higher valuation may be justified due to the influence of the internet and lower interest rates, the stock market has now crossed a boundary that it has never crossed before. In October, the Buffett Indicator surpassed 200% for the initial time in history, and it reached a peak of almost 206% on November 10. These figures are significantly higher than the respective peaks of 144% during the dot-com bubble and 107% preceding the financial crisis.
Although the Wilshire 5000-to-GDP ratio is not designed to forecast specific downturns or upturns in the major stock indices (like the Dow Jones, S&P 500, and Nasdaq Composite), it has an impressive track record of indicating potential declines in stocks when valuations become historically extended.
- The significant increase in the Buffett Indicator from 60% to 144% during the late 1990s, leading to the dot-com bubble's burst in March 2000, was followed by a near-half reduction in the S&P 500 and more substantial losses in the tech-heavy Nasdaq.
- Another substantial rise occurred between the dot-com bubble's nadir, achieved in October 2002, and the 107% Wilshire 5000-to-GDP ratio that was attained in 2007 before the financial crisis unfolded. During the Great Recession, the benchmark S&P 500 lost 57%.
- Since hitting a low of 112% on March 22, 2020 (amid the height of the COVID-19 crash), the Wilshire 5000-to-GDP ratio has soared to the aforementioned 206%. If historical precedents hold any weight, investors should (at some point) anticipate a significant decline or sharp fall in the three major stock indexes.
Despite these warning signals, time and a patient mindset can eventually yield substantial rewards for investors.
To put it plainly, historical data suggests that economic downturns, often referred to as recessions, are a normal and frequent component of our economic journey. Despite the undesirable effects on employment and income that often accompany these periods, they're not uncommon over the long haul.
However, the potential for individuals to take a step back and widen their perspective offers a different narrative. Although recessions are common, they've generally resolved swiftly since the end of World War II in 1945. Out of the 12 economic slumps in the U.S. during the last 79 years, nine ended within a year, with the remaining three surpassing but not exceeding 18 months in duration. The vast majority of economic expansions have outlasted the longest post-World War II U.S. recession.
This comparison illustrates that economic cycles are not uniform. In essence, the U.S. economy tends to spend a disproportionate amount of time in prosperous conditions rather than in periods of economic turmoil. This is fantastic news for prominent American businesses, as this non-linear pattern extends to the stock market.
It's now undeniable. A new bull market has begun. The S&P 500 has surpassed its 10/12/22 closing low by 20%. The previous bear market saw the index plummet by 25.4% over a 282-day period. These findings were shared on social media platform X by the experts at Bespoke Investment Group in June 2023, shortly after the S&P 500 was identified as entering a new bull market.
The data set provided by Bespoke Investment Group includes the duration of every bear and bull market for the S&P 500, tracing back to the onset of the Great Depression in September 1929.
The typical length of a S&P 500 bear market, which is characterized by a decline of at least 20% from a recent high, is calculated to last 286 calendar days, or roughly 9.5 months. On the other hand, the typical bull market has persisted for 1,011 calendar days, which is more than three times as long.
Perhaps the most striking revelation is that 14 out of 27 S&P 500 bull markets (including the current one) have surpassed the longest S&P 500 bear market on record (630 calendar days). Regardless of how alarming short-term predictive indicators may seem, they pale in comparison to an investor's greatest asset: time.
In light of the current bull market, individuals might want to consider their finance strategies for investing in stocks. Given the recent historical data, the Wilshire 5000-to-GDP ratio, also known as the Buffett Indicator, has reached unprecedented levels, exceeding 200%, a figure significantly higher than during the dot-com bubble and the Great Financial Crisis. This indication might be a cause for concern for some investors, as this metric has a tendency to foreshadow potentialdeclines in the stock market when valuations become historically extended.
Given the longevity of past bull markets, it's worth noting that these warning signals do not automatically imply an immediate downturn in the stock market. Historically, economic downturns, or recessions, have been common, but they've typically lasted for relatively short periods and have been followed by periods of economic growth. Therefore, while it's essential to be cautious, it's also important to remember that a patient and long-term investment strategy could potentially yield substantial rewards. In this context, one might want to consider using their money to invest in stocks, given the potential for growth in the long term.
