While our natural tendency is to get nervous about all-time highs, historical market studies suggest markets will keep climbing
Pop quiz …
Would you rather sink a chunk of hard-earned money into the market when stock valuations are in the bargain bin and continue to drift lower to increasingly attractive prices?
When valuations are lofty, the market is setting new highs, and prices continue to get increasingly expensive?
Well, this is one of “devil in the detail” situations …
The truth is that buying into a high-valuation market that’s setting new highs and getting increasingly expensive is actually more likely to make you money than buying into a market with wonderfully cheap prices that are getting cheaper.
For a time, that is … and that’s where things get a little tricky.
But let’s hold on the “time” aspect of this for a moment.
One of biggest reasons why expensive, climbing markets will often make you even more money is due to the investment phenomenon known as “momentum.”
Think back to 11th grade physics class and Newton’s First Law (abridged): An object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force.
So, when stocks are pushing higher — even though they might be expensive — that upward momentum tends to continue driving them higher.
On the other hand, when stocks are trading at wonderfully-low valuations — but they’re falling — well, they often continue falling, also due to momentum. And that “cheap” price at which you bought in suddenly has you 10% – 15% underwater as the stock continues getting cheaper.
***If you want to simplify investing, you could break down the market into just four quadrants
These four quadrants would describe a market by its valuation and its direction (for our purposes, momentum).
The best quadrant is obviously number-one. That’s when valuations are low and stocks are climbing. In this case, you have long-term factors on your side (low valuations), which work to your advantage as the market moves higher toward its longer-term average valuation.
Plus, you have short-term factors on your side in that momentum is driving higher. In this quadrant, big gains can pile up quickly.
But the second-best quadrant we could be in is quadrant-two — when stocks are expensive but still climbing. That’s where we are at today.
This quadrant is second-best because momentum trumps valuation (in the short/medium term, that is). And so, even though stocks are more expensive, momentum is driving them higher.
Regular Digest readers will recognize the name “Meb Faber.” He’s a highly respected quant investor who runs Cambria Investment Management, which offers a portfolio of ETFs.
Meb just wrote a post on this topic, beginning it with the question “is buying stocks at an all-time high a good idea?”
No, it’s not a good idea, which should surprise no one.
The fact that it is a GREAT idea, well, that should surprise everyone.
Meb ran a study, taking it all the way back to the 1920s. The rule was simple: at the end of each month, look to see if stocks are at an all-time high. If they are, then invest in stocks for the next month. If they’re not, then invest in bonds.
It turns out this “switch” strategy offered better returns than a buy-and-hold “just stocks” approach. And it offered lower volatility with significantly lower drawdowns.
Here’s Meb’s chart comparing the “ATH Switch” (meaning “At The High”) versus Buy-and-Hold.
I don’t think the takeaway is really that this is a system anyone would want to implement, but rather, an acknowledgement that all-time highs are nothing to be afraid of …
***Meb isn’t the only analyst telling investors not to fear new highs
Our own Jeff DeMaso made this same point to his subscribers last week. Jeff is the editor of The Independent Adviser for Vanguard Investors.
From Jeff, last week:
The S&P 500 Index closed at a new high (last) Monday and looks poised to do so again today.
At some point, the next new high will be the “last” new high before a bear market. Who knows? Maybe today is the top before a bear market — or simply a steppingstone to further gains.
No one has a crystal ball that can tell them when the market has hit its apex and trying to time the market’s top is a fool’s errand.
Consider that since the S&P 500 Index’s inception in 1957, there have been 1,065 new highs (ignoring dividends) and just nine bear markets (using a strict 20% drawdown definition of a bear market).
In other words, 99% of new highs were followed by another new high, and just 1% marked the absolute top.
How easily do you think you’d be able to identify that 1%?
***So, what evidence are we seeing that this current new high isn’t the “1%” top?
For that answer, let’s turn to John Jagerson and Wade Hansen of Strategic Trader. In an update to subscribers last week, the guys pointed toward increasing signs of bullishness:
Historically, when traders are optimistic about the future of the stock market, they push their money into stocks from more aggressive sectors, like the financial, consumer discretionary, technology, basic materials and industrial sectors (see Fig. 1).
So, what’s happening now?
John and Wade posted returns from the 10 S&P 500 sectors since the beginning of October, noting the top three:
• Financial Select Sector SPDR Fund (XLF): 7.55%
• Industrial Select Sector SPDR Fund (XLI): 7.32%
• Technology Select Sector SPDR Fund (XLK): 6.56%
Here’s their takeaway:
Seeing the financial, industrial and technology sectors leading the way higher for the past month tells us traders are gaining confidence.
John and Wade then pointed toward three additional signs of bullishness: small-cap stocks are breaking through resistance, the VIX is falling (which means investors are less nervous about markets), and longer-term bond yields are breaking higher.
***And there’s yet another reason to believe the market hasn’t hit a top yet — a cash pileup
Last week, The Wall Street Journal reported that investors have socked away $3.4 trillion in cash.
According to Lipper data, assets in money-market funds have grown by $1 trillion over the last three years. They’re now at their highest level in about a decade.
The benefit of this is that there’s plenty of money on the sidelines waiting to enter the market if prices drop, presenting attractive entry-points. You might think of this cash as a buoy, helping support market prices … at least for a while.
But this brings us full circle to a point we sidestepped at the top of this Digest — “timing.”
***Beware of quadrant 3
Let’s revisit our quadrants from above …
Obviously, after quadrant two comes quadrant three — a time of wealth destruction.
Overvalued markets that are falling back toward long-term averages, coupled with negative momentum is a surefire recipe for losing money.
But the thing is no one knows when quadrant two will become quadrant three. And, at present, valuations aren’t egregiously lofty. So, there’s reason to believe the markets have more juice in them. But the question of when market conditions will change remains.
Now, if you’re a younger investor with decades until retirement, this question is largely moot. You simply keep your money invested and don’t worry about these market cycles.
But if you’re an older investor needing to protect capital for retirement, then timing becomes vastly more important.
So, what’s this type of investor to do?
Well, remember — investing isn’t a binary thing. Many of us tend to think of being “all in” or “all out.” Dumping cash in at market lows, then selling out with big profits at market tops — of course, this often leads to regret when our timing is wrong … which it usually is.
Perhaps a more balanced approach would be to remain invested, yet simply increase or decrease our portfolios’ exposure to the markets relative to our own unique situation. Moving away from binary thinking usually results in greater peace.
As we wrap up, the markets are setting new highs, but history suggests that rather than fear them, we should look for more gains to come.
But also remember quadrant three is next. So, give some thought to how you might scale your positions today to have greater peace.
Have a good evening,