In the recent month, Wall Street has reminded investors that stock prices can decrease just as quickly as they can increase.

This year, the well-known Dow Jones Industrial Average (DJINDICES: ^DJI), the benchmark S&P 500 (SNPINDEX: ^GSPC), and the growth-oriented Nasdaq Composite (NASDAQINDEX: ^IXIC) have all reached new record highs several times. This phenomenon aligns with historical trends, indicating that major stock indexes tend to rise in value over extended periods, eventually recovering from corrections, bear markets, and crashes.

Nonetheless, history has its complexities.

Among the three main indexes on Wall Street, the Nasdaq—led by growth stocks—has suffered the most severe declines. Between August 1 and August 5, the index, which played a significant role in boosting the wider market, plummeted by 1,399 points. This included a significant loss of 576 points on Monday, August 5, marking the eighth largest drop in points in the Nasdaq’s history.

While investors may hope for a quick rebound from the current downturn in the Nasdaq, historical evidence suggests a more pronounced decline may still be forthcoming.

Significant overvaluation of stocks positions the Nasdaq for potential steep losses

Although history may not exactly copy itself on Wall Street, it does exhibit recurring trends. One clear indicator that the current downturn in the Nasdaq Composite may just be beginning is the Shiller price-to-earnings (P/E) ratio, often known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio.

The traditional P/E ratio, which measures a company’s share price against its earnings per share from the last 12 months, is a popular valuation tool among investors. In contrast, the S&P 500’s Shiller P/E ratio is based on a decade’s worth of inflation-adjusted earnings, which helps to iron out the effects of significant events, such as the COVID-19 pandemic, that can skew standard valuation methods.

S&P 500 Shiller CAPE Ratio data by YCharts.

At the close on August 8, the S&P 500’s Shiller P/E stood at 34.30, nearly double its historical average of 17.14 dating back to 1871.

Since the mid-90s, a Shiller P/E above its historical average has become somewhat commonplace, as the internet has made information more accessible and low interest rates have encouraged riskier investments leading to price surges.

However, every time the S&P 500’s Shiller P/E has climbed over 30 during a bull market, it has historically spelled trouble. Since January 1871, there have been just six occurrences, including the current one. After the previous five instances, the Dow Jones, S&P 500, and/or Nasdaq Composite experienced declines ranging from 20% to 89%. Essentially, the market can only sustain high valuations for a limited time.

It’s important to note that the Shiller P/E isn’t designed to predict timing, and elevated valuations can persist for weeks, months, or even years, as was the case before the dot-com bubble burst.

Nevertheless, based on historical patterns, Shiller P/E figures exceeding 30 have typically reverted to around 22, plus or minus a bit. This indicates the S&P 500 may potentially lose around a third of its value, with the Nasdaq likely facing even larger losses.

Changes in monetary policy could signal troubles for Wall Street

While not a direct indicator like the Shiller P/E ratio, the monetary policy set by the Federal Reserve tends to hold historical significance for Wall Street.

At first glance, one might assume that rising interest rates would adversely affect stock prices, while lowering rates would be a positive sign. However, this is not necessarily true for stocks.

Conversely, when rates are decreased, it typically indicates underlying problems with the U.S. economy.

The overall economic landscape or unexpected events can have a significant impact on financial markets. While lower lending rates will eventually encourage borrowing among consumers and businesses, it may take more than a year for these changes to truly resonate throughout the economy.

Data on Effective Federal Funds Rate from YCharts.

Since the beginning of the 21st century, the initiation of rate-cutting cycles has often preceded declines in stock prices:

• On January 3, 2001, amidst the collapse of the dot-com bubble, the Federal Reserve started reducing rates from 6.5% to 1.75% within a year. However, it took 645 days after this initial reduction for the stock market to hit its lowest point.
• On September 18, 2007, as the financial crisis intensified, the Fed initiated another rate-cutting cycle that brought the federal funds target down from 5.25% to a range between 0% and 0.25%. Notably, stocks didn’t reach their lowest point until 538 days later.
• The third and final rate-cutting cycle of this century began on July 31, 2019, ultimately returning the federal funds rate to the 0%-0.25% range. The stock market hit its lowest value 236 days after the first cut at the start of the COVID-19 pandemic.

On average, since 2000, it has taken 473 calendar days (over 15 months) for the stock market to hit bottom after an initial rate cut. Given that the central bank is expected to commence a rate-reduction cycle in September, historical trends indicate that challenges could be ahead for the Nasdaq Composite and stocks in general.

Long-Term Investors Have a Historical Advantage

While it’s crucial to recognize the dual nature of historical trends, it’s equally important to understand that economic and stock market fluctuations are not always predictable. If you have to choose between optimism and pessimism, history suggests that a positive outlook is more beneficial, particularly with a long-term perspective.

For example, economic expansions and contractions do not mirror each other. Since World War II, the U.S. has experienced 12 recessions, with only three lasting over a year, and none lasting longer than 18 months. In contrast, two expansions lasted over a decade. This pattern indicates that the U.S. economy is frequently in a growth phase, which logically leads to increases in sales and profits for businesses over the long term.

Although the stock market and the overall economy can behave independently, we observe similar patterns in their ups and downs.

Research from last year by Bespoke Investment Group analyzed the average duration of bear and bull markets in the S&P 500 since the Great Depression began in September 1929. In total, they reviewed 27 different bear and bull markets.

The findings indicated that the average bear market for the S&P 500 lasts only 286 days (around 9.5 months), while the average bull market lasts 1,011 days—3.5 times longer. Notably, 13 of the 27 bull markets exceeded the length of the longest bear market.

While history suggests that the Nasdaq Composite and other stocks might see a significant decline in the months ahead, this drop could represent yet another opportunity for long-term investors to purchase shares in high-quality companies at attractive prices. Keeping a balanced perspective and learning from past trends can be very profitable for investors who are patient.

Sean Williams holds no positions in any of the mentioned stocks. The Motley Fool also has no positions in these stocks. For more details, visit The Motley Fool’s disclosure policy.

The Motley Fool is a content partner of YSL News, dedicated to providing financial news, insights, and analyses to help people manage their finances effectively. Its content is created independently of YSL News.

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