For over 18 months, the bulls have dominated Wall Street, with major indexes such as the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite reaching new all-time highs. Since the beginning of 2023, these indexes have surged by 23%, 44%, and 71%, respectively. However, history shows that stocks rarely move up in a straight line, indicating that corrections and bear markets are a natural part of the investment cycle.
Currently, two historically flawless metrics are signaling a potential significant downturn for the stock market. These metrics, which have never been wrong when back-tested for over 150 years, suggest that a sizable downdraft could be on the horizon for the Dow Jones, S&P 500, and Nasdaq Composite. This forecast has prompted a critical reevaluation of portfolios, leading some investors to sell off certain holdings in anticipation of a market decline.
Decline in U.S. M2 Money Supply
The first metric raising concerns is the U.S. M2 money supply, which has meaningfully declined for the first time since the Great Depression. Economists often pay close attention to M2, which includes all cash, coins, demand deposits, money market accounts, savings accounts, and certificates of deposit below $100,000. Over the past nine decades, the M2 money supply has been on a consistent rise, reflecting the growing capital needed to facilitate transactions in a thriving U.S. economy.
However, since reaching an all-time high in April 2022, the M2 money supply has declined by an aggregate of 3.49%, with a peak drop of over 4.7% on a year-over-year basis in late 2023. This marks the first decline of at least 2% from an all-time high since the Great Depression. Historically, such declines have been associated with economic depressions and double-digit unemployment rates. Although there has been a slight rebound in the year-over-year M2 money supply, the overall decline suggests potential pressure on discretionary spending.
Elevated Shiller P/E Ratio for the S&P 500
The second concerning metric is the Shiller price-to-earnings (P/E) ratio for the S&P 500, also known as the cyclically adjusted price-to-earnings ratio or CAPE ratio. This ratio is calculated based on the average inflation-adjusted earnings over the past decade. Recently, the S&P 500’s Shiller P/E ratio ended at 35.76, slightly below its recent peak of around 37 but more than double the historical average of 17.14.
Historical data indicates that when the Shiller P/E ratio surpasses 30, it precedes significant market downturns. In the past 153 years, whenever the ratio has exceeded this threshold, the S&P 500 and/or Dow Jones Industrial Average have eventually lost between 20% and 89% of their value. Although the Shiller P/E ratio is not a precise timing tool, extended valuations are typically not sustained over the long run. With the current ratio near 36, it appears only a matter of time before the market experiences a substantial correction.
Stocks Sold in Anticipation of Market Decline
In response to these warning signs, some investors have proactively adjusted their portfolios by selling off certain stocks. Three notable stocks sold ahead of the anticipated market plunge are Intuitive Surgical, Vertex Pharmaceuticals, and ExxonMobil.
- Intuitive Surgical: Despite its strong performance and first-mover advantages in the robotic-assisted surgical systems market, the stock was sold due to its high valuation. Shares were trading at approximately 60 times forward-year earnings, which was considered unsustainable.
- Vertex Pharmaceuticals: Known for its dominance in the cystic fibrosis treatment market, Vertex Pharmaceuticals was sold due to overvaluation. The stock was trading at 12 times current-year sales and 27 times forward-year earnings, fully valuing its growth prospects.
- ExxonMobil: The oil and gas giant was sold due to its cyclical nature and high price-to-book value. With commodity-based businesses prone to emotional swings, a potential decline in crude oil demand could negatively impact ExxonMobil’s valuation.
These strategic moves were made to mitigate potential losses and to position for reentry into these stocks if their prices drop significantly. As the market braces for a potential downturn, careful portfolio management remains crucial for navigating uncertain times.
