Regardless of whether you are a Wall Street professional or a daily investor, 2022 has been a historically challenging year. the S&P 500 (SNP INDEX: ^ GSPC)which is often considered the health barometer of the stock market, has recorded the worst first-half performance since 1970. Meanwhile, the Nasdaq composite (NASDAQ INDEX: ^ IXIC) it fell as much as 34% below its mid-November high. In other words, both widely followed indices have firmly entered a bear market.
These declines come in the wake of consecutive quarterly retracements in US gross domestic product, as well as a staggering 9.1% inflation rate in June 2022. This is the highest inflation reading in just over four decades.
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Although history suggests that the S&P 500 and Nasdaq are likely headed even further down, one investment strategy has been foolproof in making patient investors richer.
History is no friend of Wall Street, at least in the short term
Before we get to the one solid strategy that hasn’t disappointed long-term investors for more than a century (and beyond), let’s tackle the elephant in the room: history. As much as investors love when the stock market is bullish, three indicators with a successful track record of calling bear market lows imply that the S&P 500 and Nasdaq Composite need to fall further.
For example, using debt on margin predicted each of the last three bear markets before they occurred. “Margin debt” is the amount of money that investors borrow from their brokerage, with interest, to buy or sell securities short. While it is perfectly normal to see margin debt increasing over time as the value of your shares increases, it is not normal for outstanding margin debt to increase rapidly over a short period.
Since early 1995, there have been three cases where margin debt has increased by a minimum of 60% over a final 12-month (TTM) period. It occurred immediately before the dot-com bubble burst, which saw the S&P 500 drop to 49% of its value. It happened again a few months before the financial crisis took shape in 2007, which caused the S&P 500 to drop by a peak of 57%. Finally, it happened in 2021 and we have already seen the S&P 500 lose up to 24% of its value. This indicator would suggest that further downside is likely.
The S&P 500’s Shiller’s price-to-earnings (P / E) ratio (also known as the cycle-corrected P / E ratio or CAPE ratio) is another worrying indicator in the short run. Shiller’s P / E ratio looks at inflation-adjusted earnings over the past 10 years, as opposed to a more traditional P / E ratio, which is above the TTM.
Since 1870, there have been five instances where the Shiller P / E ratio of the S&P 500 exceeded and held above 30 in a market bull run (the Shiller P / E reached 40 in January 2022). The previous four cases where this occurred resulted in a decline of between 20% and 89% for the benchmark index. While an 89% decline similar to the Great Depression is incredibly unlikely today due to the various monetary and fiscal tools available, a bear market was the minimum expectation for the broader market as valuations stretched.
The third indicator of concern is the forward P / E ratio of the S&P 500. A forward P / E ratio examines a company’s stock price – or in this case, the point value of an index – versus its expected earnings per share. Wall Street in the next fiscal year. Historically, the S&P 500’s forward P / E ratio has hit a low between 13 and 14 during bear markets. It was still at 16.3 last weekend, implying a further downside.
This investment strategy has beaten 1,000 for over a century
However, there is an investment strategy that, for more than a century, has made bear market dips and stock market corrections a moot point. Above all, patience is the only thing required for the success of this investment strategy.
Each year, stock market analyst Crestmont Research publishes data on 20-year rolling total returns, including dividends paid, for the S&P 500 dating back to 1919. For example, if you want the 20-year rolling total return for the ‘final year of 1977, Crestmont would look at total return for the years 1958 to 1977. Crestmont’s latest report provided the 20-year rolling total returns (presented as an annualized average) for all of the final 103 years from 1919 to 2021 .
The result? If you have purchased an S&P 500 tracking index at any time since 1900 and (key point) maintained this position for at least 20 years, you made money – and often quite a lot. About 40% of the past 103 years have produced an average annual total return of 10.9% or more. By comparison, the 20-year average annual total return of the S&P 500 was less than 5% only a couple of times over the final 103 years. This data is exactly why billionaire Warren Buffett suggests investors buy an S&P 500 index fund.
The two most popular index funds to take advantage of this seemingly foolproof investment strategy are the SPDR S&P 500 ETF Trust (NYSEMKT: SPY) and the Vanguard S&P 500 ETF (NYSEMKT: VOO). While both index funds attempt to mirror the daily price action of the S&P 500, there is a noticeable difference. Although the SPDR S&P 500 ETF Trust offers a reasonably low net expense ratio of 0.09%, the Vanguard S&P 500 ETF has an edge over its competitor with a net expense ratio of just 0.03%. In other words, only $ 0.30 of every $ 1,000 invested will go to management fees with the Vanguard S&P 500 ETF.
It’s an extremely low price to pay for the opportunity to ride the S&P 500 higher and take advantage of what has been an unstoppable investment strategy for more than a century.
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Sean Williams has no position in any of the titles mentioned. The Motley Fool has positions and recommends the Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.