The market just had an amazing past 12 months. Investors pushed through the S&P 500 losing over a third of its value in under five weeks during the first quarter of 2020. Only to then experience a record-breaking rally which took the market all the way to all-time highs in just five months time.
Shockingly, 2020 ended with the S&P 500 still higher by 16%, which means an almost doubling of its normal annual return rate. Very good considering that the pandemic hit the economy hard.
Generally speaking, these numbers precede a market crash
Most investors are wondering if the market is overheating.
Let’s consider this: Since 1950, the S&P 500 has went through 38 corrections of 10% or higher. That’s one large move downward every 1.87 years. We might not know the month a crash could happen, or how bad it will be, but we do understand that one is always around the corner.
One thing we can do is study history for guidance. One sign in particular is currently flashing that big problems are nearly here.
The Shiller P/E ratio is based on past 10 years’ average inflation-adjusted earnings. And 150 years of this metric has an average of 16.8. But currently, the Shiller ratio for the S&P 500 is calculated at 34.5 — more than 2x its normal, historical average.
There have been just five occurrences when the S&P 500 has had a P/E above 30:
- 1929: Right after Black Tuesday, the Dow lost about 89% of its total value.
- 1997-2000: Preceding the tech bubble burst, the Shiller ratio was at a record of 44.2. Then, almost 50% of the value of the S&P 500 was destroyed when the bubble burst, with the Nasdaq being slammed even harder.
- Q3 2018: During Q3 of 2018, the ratio was over 30. This was right before the Q4 selloff when the S&P 500 shed as high as 19.8%.
- Q4 2019/Q1 2020: Before the covid crash of 2020, the Shiller metric went over 30. The S&P 500 then dropped 34% in February and into March.
History teaches us that when the Shiller ratio goes over 30, bad things are coming. Of course, it’s not possible to predict when Covid might upend the best bull market in history. But regardless, history has shown when stocks reach two to three times higher than their long-term average, a crash happens soon after.