S&P 500 flashes rare signal that hints a recession, stock drop is looming

The stock market is flashing a rare omen that has historically pointed to a coming recession, Ned Davis Research says.

In a note on Wednesday, the market research firm highlighted a signal that has rarely been seen in the S&P 500, but is has cropped up this year: the index’s price-to-forward earnings ratio, a valuation metric that measures the price of the S&P 500 relative to the 12-month forward earnings expectations for companies in the index, has dropped sharply, falling by 4.4 points in the year through October.

The S&P 500’s forward P/E ratio now stands at 18.8x. The ratio is down from the 23.2x recorded last year, which marked the index’s most expensive valuation by forward earnings since the pandemic stock boom.

A decline of that magnitude is rare, having only occurred six times since 1983, Ed Clissold, NDR’s chief US strategist, said. In five out of those six instances, the S&P 500 was in an “echo bear market” — a bear market that happens within a few years of the last recession — or the US economy was already in the midst of a recession, Clissold said.

The only exception is when the P/E ratio plunged in 1998. Back then, the economy was expanding, though the P/E measure had plunged as a result of the 1987 stock crash, he added. The US would enter a recession about two years after the signal flashed in 1988.

Moreover, it is the only time the ratio has declined in a year when the S&P 500 has been up for the last 12 months.

Here’s the rundown of every instance the P/E ratio has seen a steep drop:

Stocks have also historically been volatile in years the P/E ratio sees a steep drop. Though the index was up over the next year in five out of the six instances, the S&P 500’s average median drawdown in the year that followed was around 18%, implying that stocks tend to see “some pain along the way” after the forward P/E plunges, Clissold wrote.

He noted that this year was unusual, given that investors have discounted the likelihood of the AI boom continuing by pushing down the forward P/E ratio “by amounts normally reserved for recessions and/or bear markets.”

“The skepticism could cushion the blow if earnings growth slows next year, but history suggests that if an AI slowdown leads to a recession, the recent drop in the P/E may not prevent significant drawdowns,” he said.

The signal is coming at a sensitive time in the AI trade, with tech stocks acting exceptionally volatile in the weeks leading up to the midterm elections. Investors continued to dump some tech names on Wednesday as they took in the results from the latest midterms, attesting to worries about how Democratic lawmakers could stall data center construction at a time when that’s the main focus for hyperscalers.