For more than 18 months, the bulls have ruled the roost on Wall Street. Since 2023 began, the ageless Dow Jones Industrial Average (DJINDICES: ^DJI) , benchmark S&P 500 (SNPINDEX: ^GSPC) , and growth-centric Nasdaq Composite (NASDAQINDEX: ^IXIC) have gained 23%, 44%, and 71%, respectively, and reached fresh all-time highs.
Although all three indexes have increased in value over the long run -- which is what makes long-term investing such a fruitful strategy -- history also teaches us that stocks rarely move up in a straight line.
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As much as we might dislike the idea of stock market corrections, bear markets, and even crashes, they're a natural part of the investing cycle. At the moment, two metrics that have accurately predicted significant stock market downturns when back-tested more than a century portend a sizable downdraft to come for the Dow Jones, S&P 500, and Nasdaq Composite.
In turn, these metrics have encouraged me to revamp my portfolio, which meant sending three long-term holdings to the chopping block.
U.S. M2 money supply has meaningfully declined for the first time since the Great Depression
As a big believer that history tends to rhyme on Wall Street, the first ominous figure that suggests stocks can head notably lower in the not-too-distant future is U.S. M2 money supply.
Though there are five different measures of money supply, economists tend to pay closest attention to M1 and M2. M1 adds up all cash and coins in circulation, as well as demand deposits in a checking account -- i.e., money that can be spent at the drop of a dime. Meanwhile, M2 factors in everything in M1 and adds in money market accounts, savings accounts, and certificates of deposit (CDs) below $100,000. It's still money you can access, but it takes a bit more work to spend.
For nine decades, M2 money supply has been rising with virtually no interruption. In other words, a growing U.S. economy has required more capital to facilitate transactions.
US M2 Money Supply data by YCharts .
But since reaching an all-time high in April 2022, M2 has declined by an aggregate of 3.49% , including a peak drop of more than 4.7% on a year-over-year basis in the latter half of 2023. This represents the first decline of at least 2% from an all-time high since the Great Depression.
When back-tested to 1870, there have been only five instances where M2 fell by at least 2% on a year-over-year basis : 1878, 1893, 1921, 1931 to 1933, and 2023. All four prior instances correspond with economic depressions and a double-digit unemployment rate.
Although we've witnessed a bit of a rebound in year-over-year M2 money supply, the simple fact that M2 is still down 3.49% suggests discretionary spending could come under pressure.
The S&P 500's Shiller P/E ratio is in rarified (and worrisome) territory
The other historically flawless metric that has me believing the Dow, S&P 500, and Nasdaq Composite can plunge is the S&P 500's Shiller price-to-earnings (P/E) ratio, which is also known as the cyclically adjusted price-to-earnings ratio, or CAPE ratio .
Most investors are probably familiar with the traditional P/E ratio, which divides a company's share price into its trailing-12-month earnings per share. The Shiller P/E is based on average inflation-adjusted earnings from the prior 10 years.
S&P 500 Shiller CAPE Ratio data by YCharts .
Following two days of selling pressure, the S&P 500's Shiller P/E ended July 18 at 35.76, which is slightly below its recent peak of around 37. This is more than double the average Shiller P/E ratio of 17.14, dating back to 1871.
But what's far more concerning is what's happened to stocks the previous five times the Shiller P/E has surpassed 30 over the last 153 years. Eventually, the S&P 500 and/or Dow Jones Industrial Average went on to lose between 20% and 89% of their respective value each time.
The important asterisk to this valuation metric is that it's in no way a timing tool. While there have been instances where the S&P 500 stayed pricey for mere weeks before moving lower, the Shiller P/E stayed above 30 for four years before the dot-com bubble burst. In short, there's no formula for determining precisely when investment euphoria will fade.
Nevertheless, history is quite clear that extended valuations aren't tolerated over the long run . With the S&P 500's Shiller P/E near 36, it looks to be only a matter of time before the stock market plunges.
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Three stocks I've sold in anticipation of a big move lower for Wall Street
At heart, I'm a long-term investor. Time is an undeniable ally that tends to reward those who are patient. Moreover, it's a lot easier to sleep at night when your thesis relies on catalysts playing out over the years to come rather than worrying about what'll happen three days from now.
But just because I have a long-term view, it doesn't mean selling stocks is off-limits. With the stock market looking historically pricey, a critical reevaluation of my portfolio led me to send three stocks to the chopping block.
Intuitive Surgical
The first high-flying stock I showed the door was robotic-assisted surgical systems developer Intuitive Surgical (NASDAQ: ISRG) . This was a position that was initiated during the COVID-19 crash in mid-March 2020, which had since more than tripled in value.
On paper, there's absolutely nothing wrong with Intuitive Surgical. The company's first-mover advantages have allowed it to install more than 9,200 of its da Vinci surgical systems worldwide.
Furthermore, Intuitive Surgical is built on a razor-and-blades operating model . Initially, it sells or leases its pricey (and mediocre margin) da Vinci surgical system to hospitals or surgical centers. But the bulk of its margin comes from selling instruments with each procedure, as well as regularly servicing these systems. Over time, these higher-margin operating segments have grown into a larger percentage of net sales.
The problem I have with Intuitive Surgical is that there's no way I can justify its premium. While I don't disagree that some earnings premium is warranted for its first-mover advantages, shares are going for roughly 60 times forward-year earnings . Earnings per share growth of 12% to 15% on an annualized basis doesn't justify a P/E ratio of nearly 60.
If and when the stock market plunges, I'd expect stocks with lofty premiums to get hit the hardest. I'll be looking to reenter this position on any significant weakness.
Vertex Pharmaceuticals
The second stock I said "see you later," and not "goodbye, forever" to is specialty biotech Vertex Pharmaceuticals (NASDAQ: VRTX) . Vertex was a smaller holding of mine that I'd added in mid-June 2021 at $190 per share and recently sold near $486.
Similar to Intuitive Surgical, I have no complaints about Vertex Pharmaceuticals' operating performance. This is a company that dominates in the cystic fibrosis (CF) treatment landscape . CF is a genetic disease characterized by thick mucus production that can obstruct the lungs and/or pancreas of a patient.
Vertex has developed four generations -- and is currently working on a fifth -- of mutation-specific CF therapies and combo therapies that are pacing more than $10 billion in net sales for the current year.
The company is also working on a handful of in-house and collaborative therapies to expand its reach beyond CF. This includes the approval of Casgevy earlier this year for the treatment of transfusion-dependent beta-thalassemia.
But as with Intuitive Surgical, the valuation is an eyesore. Most biotech stocks trade at a peak of around six times sales. Vertex is nearing a multiple of 12 times current-year sales and is valued at 27 times forward-year earnings. These figures fully value Vertex's growth prospects.
If shares meaningfully pull back, I'd be happy to reenter my position.
ExxonMobil
The third stock that got the heave-ho from my portfolio of more than three dozen holdings is oil and gas giant ExxonMobil (NYSE: XOM) . This is another stock that was picked up during the heart of the COVID-19 crash in mid-March 2020.
Macro factors have been a big help for ExxonMobil in recent years. Global energy majors (including ExxonMobil) were forced to slash their capital expenditures (capex) during the pandemic due to unprecedented demand uncertainty. Even with capex spending returning to normal, the supply of crude oil remains tight. As long as this supply constraint persists, the spot price of crude should be buoyed.
Big oil companies are also known for their hearty capital-return programs . Following $17.5 billion in planned buybacks in 2023, ExxonMobil offered guidance of $20 billion in share repurchases in each of 2024 and 2025. Buybacks are often beneficial to a publicly traded company's bottom line.
But at the end of the day, commodity-based businesses are highly cyclical and prone to emotional swings. If M2 money supply and the Shiller P/E are, once again, accurate in forecasting a big move lower for Wall Street, demand weakness in crude oil and/or natural gas should knock ExxonMobil off of its pedestal.
In addition, ExxonMobil's price-to-book value of 2.6 marks a decade-high. This seems like a good time to step back and wait for its valuation to become more appealing.
Sean Williams has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Intuitive Surgical and Vertex Pharmaceuticals. The Motley Fool has a disclosure policy .
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