The Stock Market Is Plunging: Here's How Far the Dow Jones, S&P 500, and Nasdaq Can Drop, According to a Historically Flawless Indicator

The past few weeks have served as a good reminder that the stock market wouldn’t be a “market” unless equities were able to move in both directions. While uptrends have handily outlasted downdrafts spanning more than a century, it’s the emotion-driven moves lower that tend to garner all the attention.

On Monday, March 10, all three of Wall Street’s major stock indexes struggled mightily. The ageless Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and innovation-powered Nasdaq Composite (NASDAQINDEX: ^IXIC) respectively lost 890, 156, and 728 points. This represented the Nasdaq’s third-largest daily point loss in its storied history, and marked the S&P 500’s ninth-biggest single-session point decline.

These moves lower are even more dramatic when compared to their recent all-time closing highs. As of the closing bell on March 10, the Dow Jones and S&P 500 were 6.9% and 8.6% below their respective closing peaks, while the Nasdaq Composite was firmly in correction territory, with a loss of 13.4%. Nearly the entirety of the Nasdaq’s decline has occurred in a 13-session stretch.

Although there’s no way to know ahead of time precisely when the stock market will plunge, how long a decline will last, or where the bottom will be, historic precedent does tend to offer clues for investors.

Based on one historically flawless valuation indicator, which has been back-tested more than 150 years, there’s a relatively clear downside target for the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite.

There have been a couple of warning signs leading up to the stock market’s plunge over the last three weeks. For instance, the Federal Reserve Bank of Atlanta is expecting the U.S. economy to contract during the first quarter at the fastest rate since 2009, excluding the years impacted by COVID-19. Likewise, a historic decline in U.S. money supply in 2023 — the first since the Great Depression — portended trouble for the U.S. economy and Wall Street.

But the most-prevailing of all concerns is a valuation tool with an immaculate history of foreshadowing downside for the stock market.

When most investors think about measuring value, the traditional price-to-earnings (P/E) ratio probably comes to mind. The P/E ratio, which is arrived at by dividing a company’s share price by its trailing-12-month earnings per share, can be quite useful in quickly evaluating mature businesses. But its utility goes out the door when assessing growth stocks or during shock events/recessions.

This is where the S&P 500’s Shiller P/E Ratio can come in handy. Note, the Shiller P/E is also referred to as the cyclically adjusted P/E Ratio (CAPE Ratio).

The Shiller P/E is based on average inflation-adjusted earnings over the previous 10 years. Accounting for a decade’s worth of earnings history ensures that shock events and short-lived recessions don’t meaningfully skew this valuation tool.

Following the tumble the Dow, Nasdaq, and S&P 500 took this past Monday, the S&P 500’s Shiller P/E fell to 35.34. Though this is below its December high of 38.89 during the current bull market cycle, it’s still more than double its 154-year back-tested average of 17.21.

Since January 1871, there have only been six instances where the Shiller P/E has topped 30, including the present. The previous five occurrences were all followed by declines of 20% to 89% in one or more of Wall Street’s three major stock indexes. Even though the Shiller P/E can’t predict the timing of these declines, it has a flawless track record of foreshadowing eventual big pullbacks in equities.

In addition to this foreshadowing, the Shiller P/E can somewhat gauge how far the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite will fall from their highs.

Since the advent of the internet democratized access to information and online trading, the S&P 500’s Shiller P/E has often found its bottom with a reading in the neighborhood of 22. If this middle-ground figure were to serve as the foundation, all three major indexes would decline by close to 40% from their respective all-time closing highs.

While it’s not uncommon for emotions to rule the roost on Wall Street when stocks are moving decisively lower, it’s important for investors to recognize that things look vastly different the more they widen their lens.

To state the obvious, stock market corrections and headline-grabbing daily downturns are perfectly normal and unavoidable aspects of putting your money to work on Wall Street.

For example, the S&P 500 has undergone 39 corrections since the start of 1950, based on data from Yardeni Research. This works out to a 10% (or greater) drop, on average, once every 1.9 years. No amount of fiscal or monetary policy maneuvering can prevent these occasional hiccups in equites.

But there’s a milewide difference when comparing the length of bull and bear markets on Wall Street.

In June 2023, shortly after the S&P 500 was confirmed to be in a new bull market, the researchers at Bespoke Investment Group published a data set which compared the calendar-day length of every S&P 500 bull and bear market dating back to the start of the Great Recession in September 1929.

Bespoke found the average of the 27 bear markets spanning 94 years lasted just 286 calendar days, or about 9.5 months. In comparison, the typical bull market endured for 1,011 calendar days, or approximately two years and nine months.

What’s more, the S&P 500’s lengthiest bear market — 630 calendar days in the mid-1970s — is shorter than 14 out of 27 bull markets, including the current bull market, when extrapolated to present day.

The key point being that the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite spend a disproportionate amount of their time rising, which is reflective of the U.S. economy and corporate profits growing over time. Time is the greatest ally investors have, and there’s little reason to believe that this near-term volatility in stocks has altered Wall Street’s long-term uptrend.

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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.

The Stock Market Is Plunging: Here’s How Far the Dow Jones, S&P 500, and Nasdaq Can Drop, According to a Historically Flawless Indicator was originally published by The Motley Fool