Connect the dots. Read the tea leaves. However you want to describe it, investors are trying to figure out how to make sense of the stock market right now. The year started off with hopes that a new bull market could begin. With the banking crisis and persistently high inflation, though, there’s still significant uncertainty.
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Many investors are closely monitoring various indicators to attempt to determine what the market might do. One of those indicators is the highest it’s been since 2000. Here’s what it could mean for stocks.
Two indexes, one indicator
The S&P 500 is arguably the most widely followed index. It measures the performance of the 500 largest U.S. companies. The index is weighted by market cap, which means that the very biggest stocks have a more significant impact than others.
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The NYSE Composite Index isn’t followed as much as the S&P 500 is. This index includes all stocks that are listed on the New York Stock Exchange (NYSE). Some of them are American depositary receipts (ADRs) for companies that aren’t based in the U.S. Like the S&P 500, the index is weighted by market cap.
There’s an indicator that tracks the relative performance of these two indexes. It’s called the S&P 500 to NYSE Composite Index ratio. That’s a mouthful, but there isn’t a commonly used shorter name. We’ll just refer to it as “the ratio.”
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As the chart above shows, this ratio is near its highest level in more than two decades. It’s less than 5% below the record high set in December 2021.
Potential implications for stocks
What could this lofty level of the ratio mean for the stock market? The answer isn’t a good one.
Several months after the ratio peaked late in the first quarter of 2000, the S&P 500 began a sharp decline. The index continued to fall for nearly two and a half years.
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What about after the ratio hit its all-time high in December 2021? The S&P 500 sank nearly 20% in the following year.
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There’s a simple reason why the S&P 500 might fall when the ratio is really high. Remember that the denominator of the ratio reflects the performance of the NYSE Composite Index. This index has a much larger number of stocks than the S&P 500 does. When the ratio reaches high levels, it means that the S&P 500 is significantly outperforming the broader group of stocks that trade on the NYSE. A potential byproduct of this outperformance is that the S&P 500 could be overvalued and due for a correction.
Indicator, shmindicator?
The S&P 500 to NYSE Composite Index ratio isn’t the only indicator that could portend a gloomy near-term future for stocks. Another indicator — M2 money supply — is contracting by more than 2% year over year for only the fifth time in 153 years. In the previous four times this happened, significant economic downturns followed.
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Should investors run for the hills? I don’t think so. The main problem with most indicators, even those with good track records, is that their sample sizes are too small to base decisions on them.
There’s also another issue with some of the indicators: They can flash false warnings. For example, the S&P 500 to NYSE Composite Index ratio has been higher than its early 2000 level since mid-2019. The S&P 500 soared more than 60% between then and the end of 2021.
Instead of trying to read the tea leaves of the market, the best thing investors can do is to follow Warren Buffett’s advice. Don’t try to predict the market. Focus on underlying businesses and valuations. Most importantly, have a long-term perspective. If you do these things, you won’t need any indicators at all.
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