The Stock Market Just Crossed a Threshold It's Never Reached Before -- and History Is Quite Clear What Happens Next

Since reaching a bear market bottom a little over two years ago, the bulls have been running the show on Wall Street. This year, the ageless Dow Jones Industrial Average (DJINDICES: ^DJI), benchmark S&P 500 (SNPINDEX: ^GSPC), and growth stock-dependent Nasdaq Composite (NASDAQINDEX: ^IXIC) have reached multiple all-time highs.

The wind in Wall Street's sails has been a "team" effort, with the artificial intelligence (AI) revolution, stock-split euphoria, better-than-anticipated corporate operating results, a resurgence in share repurchase activity, and optimism following President-elect Donald Trump's victory all leading the charge.

While this collection of catalysts might appear unstoppable on the surface, history offers a different lesson.

Image source: Getty Images.

The stock market had previously never done this throughout its storied history

Since the height of the 2022 bear market, there have been a couple of predictive tools and correlative events that have foreshadowed trouble for the U.S. economy and/or Wall Street. The longest yield-curve inversion in history, a historically high S&P 500 Shiller price-to-earnings ratio, and the first meaningful drop in U.S. M2 money supply since the Great Depression have all previously served as warnings for Wall Street.

But perhaps nothing screams "pay attention" to investors quite like the long-term valuation metric Berkshire Hathaway's billionaire CEO Warren Buffett once touted.

In a 2001 interview with Fortune magazine, Buffett lauded the market cap-to-gross domestic product (GDP) ratio as "probably the best single measure of where valuations stand at any given moment." Even though the aptly named Oracle of Omaha has backed away from solely relying on this valuation tool, it's commonly referred to as the "Buffett Indicator" on Wall Street.

The Buffett Indicator takes the collective market value of a country's publicly traded stocks and divides that figure into its GDP. The lower the ratio, the cheaper stocks are perceived to be. Conversely, when the ratio is high, it suggests stocks are historically pricey compared to the underlying growth rate of the economy.

The most-effective way to measure the value of publicly traded stocks in the U.S. is with the Wilshire 5000 Index. Each "point" higher or lower in the Wilshire 5000 Index represents a little over $1 billion gained or lost in the aggregate market value of U.S. stocks.

JUST IN 🚨: Warren Buffett Indicator hits 200% for the first time in history, surpassing the Dot Com Bubble and the Global Financial Crisis pic.twitter.com/w0NV4RaMw7

-- Barchart (@Barchart) October 22, 2024

Based on 55 years' worth of Wilshire 5000-to-GDP ratio data, which has been aggregated by Longtermtrends.net, the average reading of this "Buffett Indicator" is about 85%. In other words, the cumulative value of U.S. stocks represents about 85% the value of U.S. GDP, on average, dating back to the start of 1970.

But after close to three decades below this mean (1970 through most of 1998), the Wilshire 5000-to-GDP ratio has spent almost the entire last quarter of a century at a premium to this average. In some respects, a more aggressive valuation is warranted. The advent of the internet positively changed the growth trajectory for corporate America. Likewise, it democratized access to information, which when coupled with historically low interest rates encouraged everyday investors to take more risk.

However, the stock market just crossed a threshold that's never been reached with this widely followed ratio. In October, the Buffett Indicator surpassed 200% for the first time ever, and it peaked at almost 206% on Nov. 10. This is well above its 55-year average and is considerably higher than the respective peaks of 144% during the dot-com bubble and 107% prior to the financial crisis taking shape.

Although the Wilshire 5000-to-GDP ratio isn't a timing tool -- i.e., it's not going to tell investors when to expect big directional moves in the Dow Jones, S&P 500, and Nasdaq Composite -- it does have an exceptionally strong track record of portending downside in stocks when valuations become historically extended.

• A sizable jump from in the Buffett Indicator from 60% to 144% from the end of 1994 until the dot-com bubble bust in March 2000 gave way to a near-halving in the S&P 500 and considerably larger losses in the tech-heavy Nasdaq.
• Another noteworthy increase occurred between the dot-com bubble bottom at 67% in October 2002 and the aforementioned 107% Wilshire 5000-to-GDP ratio that was reached in 2007 prior to the financial crisis taking shape. The benchmark S&P 500 lost 57% during the Great Recession.
• Since bottoming out at 112% on March 22, 2020 (during the height of the COVID-19 crash), the Wilshire 5000-to-GDP ratio has soared to the aforementioned 206%. If history tells us anything, it's that investors should eventually (key word!) expect a steep and/or sharp decline lower in all three major stock indexes.

Image source: Getty Images.

Time has a way of paying off handsomely for patient investors

While warning signs are readily apparent for a historically pricey stock market, perspective and time paint an entirely different picture.

For example, history tells us that recessions are a normal and inevitable part of the economic cycle. No matter how much we might dislike the adverse impact on employment and wages that accompanies recessions, they're a common occurrence over the long run.

However, the ability for workers/investors to take a step back and widen their lens presents a different story. Although recessions are normal, they've resolved quickly since the end of World War II in 1945. Out of the 12 downturns in the U.S. economy over the last 79 years, nine ended in less than a year, while the remaining three failed to surpass 18 months in length. The overwhelming majority of economic expansions have endured longer than the lengthiest recession in the post-World War II era.

What the above comparison demonstrates is that economic cycles aren't linear. In other words, the U.S. economy spends a disproportionate amount of time in the sun, rather than under storm clouds. This is fantastic news for America's most-influential businesses because this non-linearity extends to the stock market.

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

The data set you'll note above was published on social media platform X by the researchers at Bespoke Investment Group in June 2023, shortly after the S&P 500 was confirmed to have entered a new bull market. What this data set shows is the calculated calendar-day length of every bear and bull market for the S&P 500 dating back to the start of the Great Depression in September 1929.

The average S&P 500 bear market, which sees the index decline by at least 20% in value from a recent high, was calculated to last 286 calendar days, or roughly 9.5 months. On the other end of the spectrum, the typical bull market has stuck around for 1,011 calendar days, which is approximately 3.5 times as long.

What's even more telling is that 14 out of 27 S&P 500 bull markets (including the current bull market) have endured longer than the lengthiest S&P 500 bear market on record (630 calendar days).

Regardless of how worrisome predictive metrics may appear over short time frames, they can't hold a candle to investors' greatest ally: time.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.