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Where will the bear market fall? History offers a very clear clue | Smart Change: Personal Finance

Where will the bear market fall?  History offers a very clear clue |  Personal finance

(Sean Williams)

You probably don’t need me to tell you this, but 2022 was one of the most challenging years on record for everyone from Wall Street professionals to everyday investors. The first half of the year had the benchmark S&P 500 (SNPINDEX: ^GSPC), which is the broadest barometer of stock market health, posted its worst return in 52 years. The growth dependent Nasdaq Composite (NASDAQINDEX: ^IXIC) fared even worse, with the index losing as much as a third of its value on a peak-to-trough basis.

With two of Wall Street’s three major indexes falling into bear market territory – the timeless Dow Jones Industrial Average (DJINDICES: ^DJI) reached the maximum decline of 19% — and to test the resolve of investors, the critical question became: “Where will the bear market bottom?”

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Image source: Getty Images.

While the official answer is that we don’t know with any certainty, history offers a number of very clear clues as to where the S&P 500 may break through. Two indicators in particular provide a range of where we can expect the bear market to bottom.

Valuation plays a key role during bear markets

While Wall Street is willing to tolerate higher valuations when the US and global economy is firing on all cylinders, analysts and investors become much more critical of stock valuations when corrections and bear markets occur. That’s why the S&P 500’s forward-year price-to-earnings ratio (P/E) can come in handy.

The S&P 500 forward P/E divides the total point value of the S&P 500 index into the consensus earnings per share forecast for Wall Street in the coming year (in this case, 2023).

With two exceptions – the Great Recession between 2007 and 2009, where valuations were really depressed given the uncertain state of the US financial system, and the double-digit percentage pullback for the broader market in 2011 – the S&P 500’s forward P/E has accurately predicted the bottom of every other significant decline since the mid-1990s. Specifically, we saw the benchmark index’s forward-year P/E bottom between 13 and 14. This is where the S&P 500 found its bottom after the dot-com bubble in 2002, during the nearly 20% pullback in the fourth quarter of 2018, and after the coronavirus crash.

On August 31, the S&P 500’s forward-year P/E stood at 16.8. Based on the noted range of 13 to 14, this would imply further downside for the S&P 500 of 16.7% to 22.6%. In other words, as long as the earnings component of the benchmark index does not change drastically, this indicator will imply a bear market bottom between 3,061 and 3,296.

Image source: Getty Images.

Margin debt tells a grimmer story

While the S&P 500’s forward-year P/E ratio provides an upper bound of where history would suggest the bear market is headed, outstanding margin debt tells a more troubling story.

“Margin debt” describes the amount of money borrowed, with interest, by investors to buy or short sell securities. While it is perfectly normal for margin debt to increase over time as the value of US stocks grows, it is anything but normal to see margin debt increase significantly, on a percentage basis, over a short period of time.

Since 1995, there have been only three instances where margin debt has increased by 60% or more on a trailing-12-month basis. This occurred immediately before the dot-com bubble that burst in 2000, just months before the financial crisis took shape in 2007, and again in 2021. Following the previous two cases where margin debt increased by more than 60% in over the trailing 12-month period, the S&P 500 lost 49% and 57% of its respective value before bottoming out.

Simplifying to a general loss of 50% of the S&P 500’s value, the bottom range for the index, based on what margin call history tells us, is 2,409 (half of the 4,818 intraday high ).

In other words, two leading indicators with a history of successfully calling a number of bear market bottoms suggest that the S&P 500 could fall to 2,409 in a worst-case scenario, or bounce back to 3,296 if corporate earnings hold up than expected.

The one figure more powerful than any bear market sub-indicator

Obviously, these indicators can be wrong, and the June 2022 bear market low of 3,636 could hold firm for the S&P 500. If there were indicators that were right 100% of the time, every Wall Street professional and retail investor would be using them against this time.

Regardless of whether the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average have already found their respective levels or are still experiencing additional downside, one number offers a practical guarantee—and all it requires is your patience.

Each year, stock market analysis provider Crestmont Research publishes data highlighting the 20-year rolling total returns (which include dividends paid) for the S&P 500 since 1919. In other words, Crestmont looks at the average annual total return that investors would have made by buying and holding an S&P 500 tracking index for 20 years over each of the past 103 ending years (1919-2021).

The result? Investors made money 103 out of 103 times if they bought an S&P 500 tracking index and held it for 20 years. What’s more, about 40% of these 103 ending years produced an average annual total return of at least 10.9%. Investors didn’t just scrape by holding an S&P 500 index. They doubled their money about every seven years in about 40% of all rolling 20-year periods.

This means that investors should not be afraid to put money on Wall Street, either now or in the future. If you’re a long-term investor, time is a far more powerful ally than any bear market bottom indicator.

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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.

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