Wall Street Faces a More Pressing Issue than a Recession
In the current economic climate, the S&P 500 Shiller P/E ratio, a valuation tool that considers inflation-adjusted earnings over the past 10 years, has surpassed the significant threshold of 30. This development, while not guaranteeing a market crash, has historically been a warning sign of an overvalued market prone to correction or bear market phases.
The last time the S&P 500 Shiller P/E ratio was this high was in January 2022, when it peaked just above 40. Since then, both the S&P 500 and Nasdaq Composite have entered bear market territory, losing significant value.
This pattern is not new. In 1929, the Great Depression led the Dow Jones Industrial Average to lose nearly 90% of its value, and the Shiller P/E ratio surpassed 30 before the Wall Street Crash. Similarly, the ratio hit an all-time peak of 44.19 in December 1999 ahead of the dot-com bubble burst.
Historically, following a prolonged period of valuations above 30, the market has subsequently endured major corrections or bear markets, with losses ranging roughly from 20% to nearly 90%. This pattern was seen again in 2007, before the global financial crisis of 2007-2008.
Currently, with the S&P 500 Shiller P/E at about 30.55 as of July 29, 2022, this ranks as the third priciest valuation level in over 150 years, behind only late 1999 and early 2022 peaks. Historically, a read above 37 has preceded below-average returns over the next 1–3 years.
However, it's important to note that valuation extremes don’t time crashes precisely. They serve as a reliable warning sign of heightened risk and lower forward returns.
The current economic landscape is marked by a 1.6% decline in the first quarter's U.S. GDP, a 9.1% inflation rate in June 2022, and a flurry of earnings reports showing that the "E" component in earnings is worsening, potentially causing the Shiller P/E ratio to increase further.
On the brighter side, the U.S. unemployment rate is historically low, at 3.6% in June 2022, and retail sales rose 1% in June and declined by a revised 0.1% in May.
In conclusion, the current elevated valuation in 2022 fits the pattern seen in previous instances where the Shiller P/E surpassed 30, suggesting caution based on historical precedent. While the S&P 500 Shiller P/E ratio may not predict market crashes with absolute certainty, it serves as a valuable tool for investors to assess market risk and potentially adjust their investment strategies accordingly.
[1] Federal Reserve Economic Data (FRED) [2] Robert Shiller, "Irrational Exuberance" [3] Dimensional Fund Advisors [4] Yahoo Finance [5] Investopedia
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