Here’s what happens next, and what to do about it.
I come today bearing good news and bad news, and I’ll give you the good news first: The S&P 500 (^GSPC 0.08%) is no longer in a “correction.”
Since closing at its highest ever level of 6,144 on Feb. 19, this index tracking the performance of America’s 500 biggest companies tumbled quickly to close at 5,522 on March 13, 10.1% below its all-time high. It’s recovered since and, as of Friday’s market close, the S&P 500 is currently down only… 7.8% at a little under 5,668. So we’re out of correction territory, and perhaps ready to resume moving higher again.
Or perhaps not.
The U.S. Stock Market: A short history of its crashes
Established back in March 1957, the S&P 500, per se, hasn’t been around to track the entire history of the U.S. stock market. But the Standard Statistics Company, predecessor to S&P Global (SPGI 0.10%), has, starting in 1923, when it began tracking the weekly stock performance of 233 U.S. companies.
Over that roughly 100-year time period, these S&P indexes have recorded no fewer than 15 separate bear markets in which S&P companies lost 20% or more of their value. Some of these crashes were gigantic, such as the 86% decline that began in 1929, or the only slightly less terrible 60% decline that began in 1937.
Other crashes were somewhat less serious. In 1956, an event that may have sparked the creation of the S&P 500 itself saw the stock market decline only 21.5%. Or consider the 1990 bear market, which might not even have been a technical bear market, depending on how far out you count your decimals, because the decline was only 19.9% top to bottom.
Still, over time and on average, bear markets are plenty serious. Across 15 S&P bear markets in 100 years, we find investors suffer more than a 38% decline in the average stock market crash.
Why the February S&P 500 correction might be the start of something worse
That number — 38% — stuck out to me recently when considering a report from the St. Louis Fed, which crunched U.S. Bureau of Economic Analysis data to prepare a surprisingly clear graph of what “normal” corporate profit margins look like in the U.S.
Basically, they look like this:
Image source: FRED (with red lines added), via John Mauldin’s Thoughts from the Frontline newsletter.
Which is to say that, for the past 75 years or so, from 1936 through 2011 — or practically the entire history of the U.S. stock market, except only the time of the Great Depression — U.S. companies have averaged somewhere between 3.8% and 7.2% profit margins on their revenues.
Something changed in 2012, however, and then changed more dramatically when COVID-19 arrived in 2020, and pushed U.S. corporate profit margins far beyond their “normal” range. History suggests this kind of a leap higher may not be sustainable. And here’s what worries me:
Averaging profit margins of 9% today, a “reversion to the mean” to just 7.2% profit margin — the upper bound of the historical range — would imply a 20% drop in absolute corporate profits from current levels.
What happens when profit margins shrink?
Now here’s why I worry such a reversion to the mean could spark a bigger stock market collapse: When earnings decline because of smaller profit margins, the “multiples” that investors are willing to pay to own those earnings tend to decline as well. And this can hit stock markets with a double whammy, as not only do earnings fall, but the stock price that investors are willing to pay times those earnings also falls.
How does this work? Consider a hypothetical company “Capitalism ‘R’ Us” that earns $1 per share. Right now, investors are paying about 28 times earnings for the average S&P stock.
28 x $1 = a $28 stock price on Capitalism.
But now assume that, because of a shrinking profit margin, Capitalism is only able to earn $0.80 per share. Alarmed by this development, investors cut the multiple they’re willing to pay for Capitalism’s stock by, say, 25%, to 21x earnings.
21 x $0.80 = Capitalism is now worth only $16.8.
Abracadabra, Capitalism’s stock price just dropped 40%, which happens to be very close to what the data show us is the average stock market value drop in a bear market over the last 100 years.
A little good news for optimists
Now, it’s not all bad news. Despite crashing 15 times in 100 years, the S&P 500 has still averaged 10% to 11% annual growth including dividends over this same period. History gives us no reason to think that will change, so there’s still hope here for long term investors. We just may need to cross one more yawning chasm first, before growth resumes.
So, how should you prepare for it?
Refocus your portfolio on individual value stocks that you know aren’t overpriced regardless of whether “the stock market” as a whole is overpriced. Avoid leverage. Avoid debt. Avoid risky stocks, meme stocks, and crypto coins that don’t offer clear value. And when the crash comes, understand that you may not know when it will end, but you do know that it will end.
Hold on tight. Stay invested, and keep investing — in the right kinds of stocks.
