When the curtain closes on 2022 in less than three weeks, it’ll undoubtedly go down as one of the most challenging years on record for investors. There have been few safe havens, with the bond market producing its worst year in history, the benchmark S&P 500 (^GSPC -0.73%) generating its worst first-half return in 52 years, and the growth-focused Nasdaq Composite (^IXIC -0.70%) losing as much as 38% in less than a year. Including the iconic Dow Jones Industrial Average (^DJI -0.90%), which dipped as much as 22% from its peak, all three major U.S. stock indexes entered a bear market.
However, all three major stock indexes have enjoyed a healthy bounce over the past two months. In fact, the Dow Jones briefly surpassed a 20% gain from its 2022 low, causing some pundits to proclaim an end to the bear market. But in my view, this couldn’t be further from the truth.
Even though accurately forecasting when bear markets will begin, how long they’ll last, and where they’ll bottom can’t be done with any consistency over long periods, a multitude of data points strongly suggests the bear market for stocks isn’t over.
Outstanding margin debt is still a problem
The first telltale warning that we’re almost certainly witnessing a bear market rally and not an end to the 2022 bear market can be found by examining outstanding margin debt.
Margin debt is the amount of money borrowed by investors, with interest, to purchase or short-sell securities. Though margin can be used to short-sell a stock and bet on a decline in its value, it’s a common tool used by investors to increase their leverage when betting on a security to move higher. This increase in leverage can be disastrous when things don’t go as planned.
As the aggregate value of publicly traded stocks grows over time, it’s perfectly normal to see outstanding margin debt increase by a commensurate amount. What’s abnormal is when margin debt outstanding rockets higher over a short time frame. A big uptick in risk-taking by investors usually marks a top for the stock market.
As of October 2022, $649.6 billion in customer margin debt was outstanding, according to the Financial Industry Regulatory Authority, which is better known as FINRA. Although that’s down 30.6% from October 2021, this sort of year-over-year decline still isn’t indicative of a bottom. During the dot-com bubble and Great Recession, year-over-year declines in outstanding margin debt easily surpassed 40%. Until we see a true risk-off approach from investors, the bear market bottom likely isn’t it.
The S&P Shiller P/E ratio portends additional downside
Another plain-as-day warning that the bear market bottom isn’t in can be found by examining the 152-year history of the S&P 500 Shiller price-to-earnings (P/E) ratio. Keep in mind that the Shiller P/E is also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio.
Whereas traditional P/E ratios take trailing-12-month earnings or forward-year earnings into account, the Shiller P/E accounts for average inflation-adjusted earnings over the past 10 years.
The S&P Shiller P/E has an incredible track record of predicting bear markets. There have only been five times since the beginning of 1870 when the value of the Shiller P/E ratio has surpassed and sustained 30 during a bull market. The broad-based S&P 500 has subsequently declined by at least 20% following each of these peaks. Another way to think about this data is that Wall Street rarely tolerates high valuations for an extended period.
The Shiller P/E is pretty good at forecasting bottoms, too. Since 1995, a number of double-digit percentage corrections and bear markets have ended with the S&P Shiller P/E retracing to around 22, give or take a little bit in each direction. The Shiller P/E began last week at 29.79. If the stock market has, somehow, already bottomed, it would have done so with its loftiest valuation ever.
The S&P 500’s forward P/E is higher than any previous bottom
A third good reason the 2022 bear market hasn’t hit its crescendo is the S&P 500’s forward P/E ratio. The forward P/E ratio divides a company’s share price — or, in this case, the point value of the S&P 500 index — into the Wall Street consensus for earnings per share in the upcoming year.
Since the beginning of 1999, the S&P 500’s forward P/E has found its bottom multiple times between 13 and 14. This includes the 2002 dot-com bubble, the fourth-quarter correction of 2018, and the coronavirus crash in 2020. The S&P 500’s forward P/E dipped even lower during the financial crisis (2007 to 2009), but this had more to do with the dire state of the U.S. economy and financial system at the time.
The point is this: No significant downturn in the S&P 500 over the past 23 years has found its bottom at a higher valuation than a forward P/E of 14. At no point in 2022 did the S&P 500’s forward P/E dip below approximately 15.5. Worse yet, the index’s forward P/E is back to 17.4 as of Dec. 5, 2022. While that’s not particularly high, it is above average considering the adverse impact higher interest rates are likely to have on corporate earnings over the next 12 to 18 months.
Federal Reserve monetary policy tells the tale
Lastly, and perhaps most convincingly, Federal Reserve monetary policy can help investors somewhat accurately predict when the broader market will bottom out.
A lot of investors have been looking forward to what’s known as the “Fed pivot.” This would involve the nation’s central bank softening its language about the pace of interest rate hikes or perhaps even pausing future rate hikes entirely. A slowdown or halt in rate hikes presumably moves the central bank that much closer to an eventual easing cycle that’s favorable for growth stocks and businesses as a whole.
Here’s the thing: The beginning of a rate-easing cycle hasn’t once marked a stock market bottom since this century began. The Fed has undertaken three rate-easing cycles over the past 22 years — Jan. 3, 2001, Sept. 18, 2007, and July 31, 2019 — and it respectively took the S&P 500 index 654 calendar days, 538 calendar days, and 236 calendar days following the start of these easing cycles to eventually find a bottom.
Not only are we not at the beginning of a rate-easing cycle, but we’re still many, many months away from the possibility of the Fed even considering a rate cut. This would suggest additional downside awaits the Dow Jones, S&P 500, and Nasdaq Composite in 2023 (and perhaps beyond).
Now for the good news…
Despite a long list of data and metrics that point to additional downside for the stock market, the good news is that investors with a long-term mindset have little to worry about. With the exception of the ongoing bear market, every single correction, crash, and bear market in the Dow, S&P 500, and Nasdaq Composite throughout history was eventually wiped away by a bull market rally.
The value of time as an ally is particularly apparent in a research note I regularly reference that’s published annually by Crestmont Research. Crestmont examined the hypothetical rolling 20-year total returns for the S&P 500 since 1900. In other words, if you bought and held an S&P 500 tracking index for 20 years, what would your total return, including dividends paid, look like?
According to Crestmont’s data, all 103 ending years examined (1919-2021) produced a positive total return. It simply doesn’t matter when you buy an S&P 500 tracking index — as long as you held for 20 years, you made money. In more than 40% of those 103 rolling 20-year periods, investors averaged an annualized total return of greater than 10%, thereby doubling their money about every seven years.
Even though bear markets can test the resolve of investors to stay the course, the data is rock-solid that bear markets represent surefire buying opportunities for those with a long-term mindset.