Where Will the Dow, S&P 500, and Nasdaq Composite Bottom? A Historically Flawless Valuation Indicator Offers a Very Big Clue.

Over the last seven weeks, Wall Street has served up a dose of reality and reminded investors that getting from Point A to B is rarely achieved by moving in a straight line.

From Feb. 19, which is the date the benchmark S&P 500 (SNPINDEX: ^GSPC) hit its all-time closing high, through April 4, the Dow Jones Industrial Average (DJINDICES: ^DJI), S&P 500, and Nasdaq Composite (NASDAQINDEX: ^IXIC) respectively tumbled by 14.2%, 17.4%, and 22.3%. This places the Dow and S&P 500 comfortably in correction territory, with the Nasdaq Composite officially falling into a bear market.

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It's no secret that emotions tend to rule the roost when equity valuations move decisively lower. The all-important question is: How far could the Dow Jones, S&P 500, and Nasdaq Composite tumble before finding their respective bottoms?

Although no forecasting tool can answer this question with concrete certainty, there is one historically flawless valuation indicator that offers a very big clue as to where Wall Street's three major indexes may reach their trough.

Image source: Getty Images.

More than 150 years of valuation history weighs in

For the moment, all eyes are on President Donald Trump and his tariff policy. On April 2nd, a day the president has referred to as "Liberation Day," Trump introduced sweeping global tariffs of 10%, as well as an assortment of reciprocal tariffs on countries that have had unfavorable trade balances with the U.S.

Investors have no shortage of concerns when it comes to President Trump's tariff policy. There's the belief it could increase the prevailing rate of inflation, worsen trade relations with America's key trade partners, or potentially be the catalyst that tips the U.S. economy into a recession.

What's more, a December-released analysis from four New York Fed economists at Liberty Street Economics found clear negative correlations between public companies exposed to Trump's China tariffs in 2018-2019, and the performance of those stocks on tariff announcement days.

But amid all the hoopla regarding tariffs is a valuation indicator -- the Shiller price-to-earnings (P/E) Ratio -- which may be the key to forecasting the bottom of this steepening sell-off in the Dow, S&P 500, and Nasdaq.

The Shiller P/E Ratio, which is also known as the cyclically adjusted P/E Ratio (CAPE Ratio), is based on average inflation-adjusted earnings over the previous 10 years. Adjusting for inflation and examining a decade's worth of earnings data ensures that shock events don't meaningfully skew the results.

S&P 500 Shiller CAPE Ratio data by YCharts.

In December, the S&P 500's Shiller P/E hit its closing high for the current bull market cycle of 38.89. To put this figure into some context, the average Shiller P/E when back-tested over the last 154 years is 17.23. In other words, this is one of the priciest market's investors have ever witnessed.

There have only been six instances since January 1871, including the present, where the Shiller P/E has surpassed 30 and remained above this level for at least two months during a bull market. All five prior occurrences were eventually followed by 20% or greater declines in the Dow, S&P 500, and/or Nasdaq..

More importantly, the Shiller PE has commonly found its nadir around 22 over the last three decades. While it's possible it could bottom well above or below this mark, it's been something of a middle-ground valuation multiple that previously pricey markets have retraced to.

Following the two-day shellacking the stock market took to end the previous week, the S&P 500's Shiller P/E has retraced to a multiple of 31.31, as of April 4. The Shiller P/E is closing in on a 20% decline from its recent high, with the S&P 500 losing more than 17% of its value. If this ratio of Shiller P/E multiple retracement to S&P 500 decline were to continue to hold true, a trough of 22 for the Shiller P/E would see the S&P 500 lose about 39% of its value from its all-time high. This would place its bottom around 3,750.

What about the Dow and Nasdaq, you ask? Since the Dow is comprised of more mature companies, its nadir is expected to be more modest and result in a decline of around 30%. In comparison, the Nasdaq Composite is far more volatile and likely to see its potential peak-to-trough decline approach 50%.

Again, there's no guarantee any of these prognostications come to fruition; but it is what one of Wall Street's flawless valuation tools is predicting.

Image source: Getty Images.

A surefire opportunity awaits long-term investors

The prospect of the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite being only halfway (or not even halfway) to their respective bottoms is probably unnerving to some investors -- especially those that haven't endured a bear market decline in equities before. But there are a few important things to remember about stock market corrections, bear markets, and periods of heightened volatility that makes it easier to cope with these challenges.

For starters, downturns in stocks are normal, healthy, and inevitable. According to data aggregated by Yardeni Research, the S&P 500 has endured 40 corrections since 1950. In short, there's a double-digit percentage downturn in Wall Street's benchmark stock index every 1.9 years, on average. If you're a long-term investor, you're going to work your way through plenty of these hiccups.

More importantly, every stock market correction, bear market, and crash throughout history, dating back to the inception of the Dow Jones Industrial Average in May 1896, has been a surefire buying opportunity.

On one hand, stock market downturns tend to be short-lived. A comprehensive analysis from Bespoke Investment Group, which was published on social media platform X in June 2023, showed the typical S&P 500 bear market has lasted only 286 calendar days since the Great Depression. This means the average bear market resolves in roughly 9.5 months.

It's official. A new bull market is confirmed.

The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.

Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp

-- Bespoke (@bespokeinvest) June 8, 2023

At the other end of the spectrum, Bespoke discovered that bull markets last substantially longer. The average S&P 500 bull market galloped higher for 1,011 calendar days spanning 94 years.

A separate analysis from Crestmont Research further speaks to the importance of time in the market, rather than trying to time the short-term directional moves of the market.

Crestmont calculated the rolling 20-year total returns (dividends included) of the broad-based S&P 500 dating back to the start of the 20th century. Despite the S&P not coming into existence until 1923, researchers were able to track its components, and their performance, in other indexes prior to 1923. This analysis yielded 106 rolling 20-year periods of total return data (1900-1919, 1901-1920, through 2005-2024).

According to Crestmont Research's calculations, all 106 rolling 20-year periods produced a positive annualized total return. This is a way of saying that if you had, hypothetically, purchased an S&P 500 tracking index at any date between 1900 and 2005, and you held this position for 20 years, you would have generated a profit every time.

With perspective and time, every stock market correction, bear market, and crash are a buying opportunity for investors.

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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.