Indicator signifies a decrease in S&P 500's value.
Dipping into the Stock Market Chaos of 2022
Markets have been a rollercoaster these days, like they haven't been for ages. Inflation and tight monetary policy are keeping everyone on the edge. Indices like the S&P 500, Dow, and Nasdaq are in the red since the start of the year. Some investors see this as a great opportunity to catch the dip.
But, when will the bottom be reached? Many investors have been struggling with this question. If you get in too soon, it can still go down significantly, if you get in too late, you might miss out on many good entry opportunities. However, there is an indicator that has successfully predicted all five bear markets since 1870 and has an excellent record of determining when the S&P 500 will reach its low. It's called the Shiller P/E ratio.
The regular price-to-earnings ratio can be calculated by dividing the price by the expected earnings of the current fiscal year. The Shiller P/E, on the other hand, uses the average of inflation-adjusted earnings over the past ten years. The thing is: According to The Motley Fool, the Shiller P/E for the S&P 500 has only exceeded and maintained the value of 30 five times during a bull market rally since 1870. Each time, this was followed by a dip of at least 20 percent, i.e., a bear market. For example, before the Dotcom Bubble, the Shiller P/E reached an all-time high of 44.19. This year, it happened again: The Shiller P/E exceeded the value of 40 for the first time in two decades in the first week of January 2022. It should be noted that even if the value of 30 is exceeded and maintained, it's not known exactly when the peak has been reached. For instance, in the third quarter of 2020, the Shiller P/E exceeded the value of 30, but it took over a year to finally exceed 40 in January 2022.
The Power of the Shiller P/E Indicator
The Shiller P/E doesn't just warn when there's a risk of a bear market, but it also shows when bear markets will reach their lows. Before the 1990s, the Shiller P/E usually fluctuated between 5 and 25. However, since the 2000s, values between 20 and 40 have been more common, partly due to the years of loose monetary policy by central banks. As reported by The Motley Fool, the Shiller P/E has consistently found a low point of around 22 after significant market setbacks, such as the Dotcom Bubble or the correction in the fourth quarter of 2015 or 2018, or during Corona in 2020.
If the trend holds again, this means for the S&P 500: Recently, the Shiller P/E was still at 27.66. If it falls to the usual range around 22, this would mean a low point of around 2990 for the S&P 500.
It's important to note that, while the Shiller P/E can provide valuable insights into long-term valuation risk, it's less effective when it comes to timing short-term market bottoms. Investors should consider it alongside other macro variables, like interest rates and earnings trajectory, to gauge downside potential.
- The Shiller P/E indicator, which has successfully predicted five bear markets since 1870, currently indicates that the S&P 500 might reach its low at an average of around 2990, if the historical trend of falling to a range around 22 holds true.
- In finance, the Shiller P/E is an useful tool for measuring the long-term valuation risk in the stock market, as it uses the average of inflation-adjusted earnings over the past ten years to calculate the price-to-earnings ratio.
- The recent surge in the Shiller P/E for the S&P 500, which reached 40 for the first time in two decades in January 2022, has raised concerns among investors about a potential bear market.
- Some investors find the current state of the stock market chaotic, as markets have been unstable due to factors like inflation and tight monetary policy, causing indices like the S&P 500, Dow, and Nasdaq to dip since the start of the year, leading some to see this as an opportunity for investing.
