The Bull Market Enters Year Three: What History Teaches Us

The bull market is officially entering its third year, and while the S&P 500 celebrated by touching another record, investors should brace themselves for what history indicates may be a bumpy ride ahead. According to CFRA Research, every bull market that has reached its two-year anniversary since 1947 has experienced at least one significant decline in the subsequent twelve months. It’s essential for investors to remain vigilant and prepared, especially given the high valuations currently plaguing the stock market.

A Historical Perspective

Data presented by Sam Stovall, chief investment strategist at CFRA Research, reveals a stark pattern: all eleven bull markets since 1947 that celebrated their second birthday have faced at least a 5% decline within the next twelve months. These declines are no small matter; five of those markets veered into sell-offs between 10% and 20%, while three outright plunged into new bear markets.

The statistics are sobering: the average return following these eleven bull markets during their third year stands at a meager 2%. For investors riding high on the market’s seemingly relentless ascent, this information serves as a sober reminder that what goes up can—and often does—come down.

Current Market Conditions

Since hitting bear-market lows on October 12, 2022, the S&P 500 has surged nearly 64%, culminating in a closing value of 5,859.85 on Monday. Within this timeframe, the index saw a 22% advance in its first year, although this increase was one of the lowest recorded since 1947. Conversely, the second year witnessed a staggering 34% increase, outpacing the median of 11.5% for second-year gains across all historical bull markets.

However, optimism tempered by caution is critical here: large-cap stocks are currently trading under a trailing price-to-earnings (P/E) ratio of 25, marking the peak valuation for the second year of a bull market since World War II. This figure stands at an alarming 48% above the median P/E for second-year bull markets since 1947, raising flags over whether the current enthusiasm is genuinely backed by robust fundamentals.

Understanding P/E Ratios in Context

Stovall notes that P/E multiples typically decrease during the third year of a bull market, as earnings-per-share growth is generally expected to follow suit, validating the earlier bullish price movements. Analysts project year-over-year earnings growth rates at 14.2%, 13.9%, and 13.1% for the fourth quarter of 2024 and the first and second quarters of 2025 respectively. The overall outlook is for earnings to grow by approximately 15% in fiscal-year 2025, compared to about 10% growth in 2024.

The Bull Market: A Double-Edged Sword

While there’s a sense that the stock market remains buoyed by positive sentiment, one can’t disregard the cautionary tales of our financial elders. In a world increasingly driven by political instability and economic volatility, it’s vital for investors to maintain a healthy skepticism. Wall Street may be riding high as investors anticipate forthcoming corporate earnings reports, but history has shown us that such euphoria can dissipate quickly. Just look at how swiftly a bullish environment can succumb to bearish forces when warning signs—including elevated valuations—are ignored.

The Dow Jones Industrial Average was up over 200 points (0.5%), and the Nasdaq Composite gained 0.9%, but we must question the sustainability of this growth amid overarching market concerns. The performance is not indicative of an unshakeable bull market; rather, it is a reminder that markets are cyclical, and investors should act accordingly.

The Conservative Investor’s Playbook

For conservative investors, strategic planning becomes crucial in an environment where historical patterns suggest potential declines. Protective measures could include reassessing portfolio allocations, diversifying investments, and considering hedging strategies that shield against volatility. Tools such as options trading and short selling should not be considered taboo; instead, they are prudent mechanisms to protect profits accrued during the past two years of growth.

Conclusion

As the bull market embarks on its third year, the finger is on the pulse of the stock market, and caution is advised. The stories of past markets pave a path for today’s decisions. Investors should remain vigilant, prepared for the unexpected, and adapt strategies that honor time-tested principles over fleeting optimism. The financial landscape is as fragile as it is promising, and history, as always, offers us its duly earned wisdom.