Sure, we’re in a “recession,” but there’s a much bigger concern for Wall Street.

JTo be perfectly frank, this has been an abysmal year for Wall Street. The reference S&P500 (SNP INDEX: ^GSPC) had its worst first-half performance in a year since 1970. We also witnessed the index that drove Wall Street higher after the coronavirus crash of 2020, the Nasdaq Compound (NASDAQ INDEX: ^IXIC)have fallen 34% since November.

The impetus for these measures includes historically high inflation, which reached 9.1% in June 2022, Russia’s invasion of Ukraine, further crippling global energy supply chains, and policy change aggressive monetary policy from the Federal Reserve. The Fed has raised its target federal funds rate by 75 basis points in back-to-back meetings.

Now we can add a new catalyst to the list: a “recession”… of sorts.

Image source: Getty Images.

Are we in a recession? It really depends on your school of thought

For many investors, there is a broad definition of what a recession is that is now accepted. If the US Gross Domestic Product (GDP) declines for two consecutive quarters, the widely held belief is that the US economy is in recession.

At the end of June, the Bureau of Economy Analysis (BEA) released its final estimate of first-quarter US GDP, which showed a decline of 1.6%. On Thursday, July 28, 2022, the BEA released its advanced estimate (essentially its first early look) of second-quarter US GDP, which showed a 0.9% retracement. Cross the ‘T’s and cross the ‘I’s, and it looks like a recession for the US economy.

However, technically, a recession is more than two consecutive quarters of declining GDP. Officially, a committee of eight economists part of the National Bureau of Economic Research (NBER) decides whether or not a recession occurs. Although GDP is one of the factors taken into account, this committee also takes into account consumer spending, retail sales, employment data (both non-farm payroll employment and surveys of households), personal income and industrial production. The NBER is the official arbiter of whether the United States is in a recession.

For example, retail sales and employment data do not paint a picture of the US in recession. The Commerce Department noted in its news release in mid-July that retail sales rose 1% in June and fell a revised 0.1% in May. This would suggest that consumers continue to spend freely. Again, with the prices of goods and services skyrocketing, what choice do consumers have but to open their wallets a little more?

The unemployment rate in the United States is also historically low – 3.6% in June 2022. Normally, we would see evidence of job losses and an increase in the unemployment rate during a recession.

A portrait of George Washington on a dollar bill placed next to a newspaper clipping of a plunging stock chart.

Image source: Getty Images.

Wall Street has a lot more to worry about than whether or not we’re in a “recession”

While the “R” (recession) word is usually enough to shake Wall Street’s confidence, there is a much bigger concern that is front and center and quite capable of dragging the S&P 500 and the Nasdaq Composite much lower. down. I’m talking about Shiller’s price-to-earnings (P/E) ratio.

I guess most investors are relatively familiar with the P/E ratio. You take the stock price of a publicly traded company and divide it into that company’s earnings per share over the 12-month period. The P/E ratio is a valuation tool that can be used to compare against similar companies or perhaps the broader market to determine if a stock is “cheap” or “expensive”.

The Shiller P/E ratio, also known as the cyclically-adjusted price-to-earnings ratio (CAPE ratio), takes into account inflation-adjusted earnings over the past 10 years. This is a more holistic look at the direction the broader market, particularly the S&P 500, has taken over the past decade from a valuation perspective.

Here’s the interesting thing about the S&P 500 Shiller P/E ratio: bad things happen when it’s above 30.

Dating back to 1870, Shiller’s average P/E ratio is 16.96. As of this writing on July 29, 2022, it’s seated at 30:55. But it’s not just the current value that’s alarming. This has happened every time the Shiller P/E has exceeded 30, as well as what the earnings outlook (the “e” component) has in store for many of Wall Street’s most important companies.

Since 1870, there have only been five times when the S&P 500 Shiller P/E ratio has exceeded and stayed above 30:

  • 1929: The Great Depression led to the Dow Jones Industrial Average (DJINDICES: ^DJI) lose almost 90% of its value.
  • 1997-2001: The S&P 500 Shiller P/E hit an all-time high above 44 during the dot-com boom. Eventually, the S&P 500 would lose almost half of its value.
  • Q3 2018: During the third quarter of 2018, the Shiller P/E ratio again exceeded 30. The S&P 500 lost 20% of its value during the following quarter.
  • Q4 2019-Q1 2020: The S&P Shiller P/E ratio’s next rally above 30 was thwarted by the COVID-19 crash, which cost the S&P 500 34% of its value in 33 calendar days.
  • Q3 2020-current: In January 2022, the S&P 500 Shiller P/E peaked just above 40. Since then, the S&P 500 and the Nasdaq Composite have both entered bearish territory.

Although easy access to information has made the investment community more tolerant of risk taking and higher P/E ratios over time, the story has been pretty clear that bad things happen. occur when the S&P 500 Shiller P/E is above 30 (as it is now).

To make matters worse, a slew of earnings reports have shown the “E” component of earnings deteriorating. With a number of influential publicly traded companies missing Wall Street’s second quarter expectations or offering tepid growth prospects for the third quarter or the rest of the year, the Shiller P/E could potentially rise.

Although valuation alone is rarely enough to bring the stock market down, the tea leaves say this is the data point you shouldn’t ignore.

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Sean Williams has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.

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