How Far Could the Stock Market Plunge? 1 Indicator May Hold the Answer.

Regardless of how long you’ve been putting your money to work on Wall Street, 2022 has been a challenging year. Since the first week of January, which is when the iconic Dow Jones Industrial Average (DJINDICES: ^DJI) and benchmark S&P 500 (SNPINDEX: ^GSPC) hit their all-time highs, both indexes have tumbled into correction territory with losses exceeding 10%.

Meanwhile, the tech stock-driven Nasdaq Composite (NASDAQINDEX: ^IXIC) has performed even worse. After hitting a record high in November, it’s fallen as much as 31%. This puts the Nasdaq firmly in the grips of a bear market.

Taking into account the heightened volatility and unpredictability that often accompanies bear markets and steep corrections in the major U.S. indexes, the big question on investors’ minds is simply this: How far could the stock market plunge?

Image source: Getty Images.

This indicator suggests the stock market may have a lot further to fall

Truth be told, there is no concrete answer to this question. We’ll never know ahead of time when a correction will start, how long it’ll last, or how steep the decline will be. In fact, in many cases we can’t even identify the expected cause of a correction until after it’s already under way. However, we do have access to economic data, and that can offer clues to how big of a drop might await the Dow Jones, S&P 500, and Nasdaq Composite.

In particular, one indicator might be particularly useful in determining how far the stock market could plunge: margin debt.

Margin debt describes the amount of money investors are borrowing, with interest, to invest in or bet against securities. While using margin can magnify gains if you correctly bet on the direction a security will move, it can also quickly accelerate your losses if you’re wrong. A bad bet using margin can even result in a margin call, which is where your broker requires you to put up additional collateral or liquidate your position at a loss.

As the aggregate value of publicly traded companies has increased over time, the amount of outstanding margin debt has increased as well. This is perfectly normal. What isn’t normal is seeing the amount of outstanding margin debt climb rapidly in a short time frame. In the few instances over the past 27 years where outstanding margin debt climbed 60% or more in a single year, the S&P 500 has plunged not long after.

For example, margin debt skyrocketed 80% between March 1999 and March 2000. The subsequent dot-com bubble-bursting event saw the benchmark S&P 500 lose roughly half its value, with the growth-focused Nasdaq tumbling close to 75%.

It happened again seven years later, when margin debt climbed 62% between June 2006 and June 2007. This was just months before the financial crisis and Great Recession took hold and eventually wiped away 57% of the S&P 500’s value.

FINRA Margin Debt data by YCharts.

Lastly, between March 2020 and March 2021, margin debt surged 72%. History would suggest that the S&P 500 could, ultimately, lose around half of its value.

A few caveats to keep in mind

But there are a few important limitations and caveats to understand about using margin debt as the end-all predictor of future stock market moves.

To begin with, the factors that lead to stock market corrections and bear markets are unique to each event. In the early 2000s, the dot-com bubble was caused by investors’ irrational exuberance in dot-com companies. Meanwhile, the subprime housing meltdown was the fuel that ignited a wave of bad loans stored on bank balance sheets between 2007 and 2009.

The current correction in the stock market is a reflection of an unprecedented event taking shape. Never before has the Federal Reserve kicked off a monetary policy tightening cycle — i.e., raised interest rates and/or reversed quantitative easing measures — into a declining stock market. In addition, multiple generations of consumers and homebuyers have never dealt with inflation of this magnitude.

Wall Street loves when history rhymes. With regard to the current situation, where the Fed is aggressively tightening into a plunging market and inflation is through the roof, there is no precedent. This effectively throws history out the window and further heightens the uncertainty on Wall Street.

The other caveat to keep in mind is that no matter how gloomy corporate forecasts get, all three major U.S. indexes have eventually gone on to erase all prior corrections and bear markets. Although some declines can take quite some time to retrace, such as the Nasdaq’s fall from grace during the dot-com bubble, history unequivocally shows that buying equities and holding them for long periods tends to be a moneymaking strategy.

Image source: Getty Images.

There are a number of smart ways to invest during a bear market

In my view, none of the three major U.S. indexes have found their bottom yet. But that doesn’t mean it’s time to run for the hills. Rather, it means investors need to be smart about how they put their money to work.

For instance, investors with cash should consider dollar-cost averaging into their favorite stocks. Dollar-cost averaging involves buying stocks at regular intervals, regardless of share price, or buying when stocks reach specific (yet arbitrary) price points. Dollar-cost averaging removes some of the emotional aspects of investing so you won’t be kicking yourself if you didn’t buy at the absolute lowest price. Plus, with most online brokerages being commission-free, there’s no harm (or cost) in constantly nibbling on your favorite stocks.

Buying dividend stocks can also be fruitful during a bear market — especially when inflation is effectively at a 40-year high. Companies that pay a dividend are often profitable on a recurring basis and time-tested. In addition, studies have shown that dividend stocks have handily outperformed non-dividend payers over the long run.

Defensive and basic necessity stocks can be smart buys during a bear market, too. For example, a plunging stock market isn’t going to change the fact that people still get sick and require medical care. This creates a base level of demand for drugmakers, medical-device manufacturers, and healthcare service providers.

Another example is electric utility stocks. Homeowners aren’t suddenly going to change their electricity consumption habits just because the stock market has had a rough couple of months.

Even growth stocks can be a smart way to take advantage of a bear market. Although you’d think value stocks would come into focus during a bear market, studies have shown that growth stocks actually outperform value stocks during periods of economic weakness.

No matter how much the stock market ultimately plunges, buyers with a long-term mindset are almost certain to be rewarded.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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