For much of last year, investing in the stock market required an iron stomach. The unprecedented nature of the 2019 coronavirus pandemic (COVID-19) has transformed social norms in their heads, put an end to the traditional work environment and launched a black cloud over stocks during the first quarter of 2020. It took just 33 calendar days (less than five weeks) for the benchmark S&P 500 (SNPINDEX: ^ GSPC) lose more than a third of its value.
Then again, it’s been mostly a roller coaster of joy since the bottom of March 23rd. The S&P 500 ended 2020 with a 16% increase (this is almost double its average annual return in the last 40 years) and started 2021 on a high note. Until Wednesday, February 3, the widely followed index rose 2% in the year.
But if history turns out to be accurate, investors shouldn’t be too comfortable with the strong start of 2021.
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Be prepared for a 20% drop in the stock market
Although day trading and the drive for momentum seem to dominate the perch in the first weeks of the new year, it is the growth in operating profits that drives stock valuations in a sustainable way in the long run. That is why it is always important to pay attention to market-based fundamentals, no matter what is going on.
The number that should make investors very concerned is the Shiller price / earnings ratio (P / E) for the S&P 500. This differs from the standard P / E ratio because it is based on the average profit adjusted for inflation over the previous 10 years, rather than just a single year’s earnings.
Looking back 150 years, the S&P 500 averaged a 16.78 P / E Shiller. It is true that Shiller’s P / E ratio has been much higher in the last 25 years. The advent of the Internet has broken information barriers for retail investors and historically low lending rates for more than a decade have fueled lending and sparked growth stocks.
But as of February 3, the Shiller P / E for the S&P 500 was knocking on the door at 35 – more than double the long-term average. To put that number in some context, there were only five periods in history when Shiller’s P / E ratio reached 30 and remained there during a bull market race. Two of these events – the Great Depression and the dot-com bubble – led to some of the biggest setbacks ever witnessed in actions. Two other events (not counting the current movement) occurred in the last three years, with decreases of 20% and 34%, respectively, in the S&P 500.
In other words, whenever Shiller’s P / E ratio exceeds and sustains 30 in a market high, this will result in a minimum decline of 20%.
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There are other reasons to worry
It is not just stretched assessments that are of concern at the moment. The nosebleed premiums built into the stock market assume that the COVID-19 pandemic will soon be a thing of the past. This may not be the case.
As an example, take a look at the latest results from the Kaiser Family Foundation (KFF) COVID-19 vaccine survey. In mid-January, KFF asked respondents about their willingness to receive at least one dose of the COVID-19 vaccine free of charge. About 6% have already been vaccinated, with another 41% willing to take it as soon as possible. Meanwhile, almost a third (31%) of respondents were in “wait and see” mode, with 20% combined “I definitely didn’t understand” or getting it only if necessary (note, the numbers don’t add up to 100% due to rounding).
That’s almost half the population who don’t want to get in line for a COVID-19 vaccine right now. According to recent comments by Dr. Anthony Fauci, vaccination rates between 70% and 85% would be required to achieve collective immunity. In other words, the pandemic may be far from over.
To develop this point, many American workers and their families rely on continuous assistance from the federal government. Millions of workers have been laid off or licensed, and some of those still working have seen their hours cut. If party disputes continue on Capitol Hill and the additional fiscal stimulus is postponed, this could have serious negative consequences on consumption (which is the main driver of the US gross domestic product) and could lead to a substantial increase in loan and credit defaults. . That would be bad news for financial stocks, which many see as the backbone of US stock markets.
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Stay on course and target the winners
However, even if a stock market crash is brewing, it is a smart move for investors to stay on course and contribute to innovative and winning businesses.
One of the most telling statistics about stock market declines is courtesy of JP Morgan Asset Management. Having analyzed the 20-year continuous returns for the S&P 500 with several different final years, one figure stands out: Approximately 50% to 60% of the best single session gains on the market occur within a few weeks of their worst single session performances. This is an elegant way of saying that if you rush to the exit, you will almost certainly miss some of the biggest bull market days. Losing a handful of those grandiose days can be detrimental to your wealth.
In addition, Crestmont Research data shows that there was not a 20-year period in the history of the S&P 500 when investors would have lost money. If an investor has purchased a S&P 500 tracking index and has maintained it for at least 20 years, he or she typically obtained a high one or two-digit average annual total return (that is, including dividends).
If a stock market crash arises in 2021, the best game plan is to stay the course and increase the stakes that keep on winning.