In financial markets, past history teaches and this time we should listen to it. In the four previous times we have seen this crash signal, the market has lost from 20% to 89%.
The stock market recently closed a historic year. At no other particular time in the past have Wall Street and investors made their way through these things:
The S&P 500 Index lost more than a third of its value in less than five weeks during the first quarter of 2020;
A record-breaking rally from the March 23rd low that allowed the S&P 500 to reach an all-time high in less than five months;
A brief, but steep negative quote on WTI oil futures in April;
Historical volatility that drove the CBOE Volatility Index or VIX to the highest values ever recorded in March 2020.
Surprisingly, with such a 'devastating' situation, the year ended with the index the S&P 500 up 16%, which is almost double its average annual return since 1980, considering that the coronavirus pandemic (COVID-19) caused havoc in the U.S. economy and the rest of the world.
Doubling of P/E
One signal is the S&P 500 price/earnings ratio (The price/earnings (P/E) ratio is a common, though not perfect, indicator for valuing stocks) based on average inflation-adjusted earnings for the previous 10 years.
Over its 150+ year history, the P/E ratio for the S&P 500 has averaged 16.8; currently, the P/E ratio for the S&P 500 is 34.5, more than double its historical average.
Looking back, there have only been five times in history when the S&P 500 has exceeded a P/E ratio of 30 and they have been:
1929: After the Black Tuesday crash (Black Tuesday we refer to the day of the stock market crash that occurred on October 29, 1929 in New York City at the Stock Exchange), the iconic Dow Jones lost about 89% of its value.
1997-2000: Before the dot-com bubble burst, the P/E ratio for the S&P 500 reached an all-time high of 44.2. Nearly half of the value of the S&P 500 was wiped out after the dot-com bubble burst, with the Nasdaq Composite hit even harder.
Q3 2018: For much of the third quarter of 2018, the P/E ratio remained above 30. This was followed by a fourth quarter market crash that saw the S&P 500 lose as much as 19.8%.
Q4 2019 / Q1 2020: Prior to the coronavirus crash in Q1 2020, the S&P 500's P/E ratio had, once again, exceeded 30. The S&P 500 index lost 34% in 33 calendar days during the COVID-19 chaos of February and March.
Don't fear the crash!
Historically, when the P/E ratio for the S&P 500 exceeds 30, bad things happen. Of course, it's impossible to predict when a pandemic might hit the longest bullish market in history. However, the history is pretty clear, and when stocks become about two or three times more expensive than their long-term average, a crash has occurred relatively soon.
Here are a few things to think about. First, stocks will benefit for many years from the Federal Reserve's historically accommodative monetary policy. In an effort to stabilize markets and strengthen the U.S. economy, the U.S. central bank has pledged to keep lending rates at or near historic lows through 2023. This is an open invitation to growth stocks to go on the offensive by taking advantage of historically low rates.
Second, history says that long-term investors should remain optimistic. Despite 38 stock market crashes and corrections over the past 71 years, the S&P 500, Dow Jones and Nasdaq Composite have always, eventually, shrugged off these declines and reached new highs. Since the operating gains for these indexes expand over long periods of time, this is what will push these major indexes higher.
Yes, there may be a stock market crash coming, but there is no doubt that this will present a buying opportunity for long-term investors.
This article does not rapresent a financial advice to invest, it's for informational purposes only.
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