Markets at highs: Panic or stay calm?

An edited version of this article was published in the 17 July 2017 issue of TODAY.

Singapore’s sovereign wealth fund GIC was recently in the news reporting a declining annualised rate of return, with the CEO saying that returns are expected to remain low over the next decade. He opined that the fund was preparing itself for a period of protracted uncertainty and low returns. One of the main reasons for this was that the investing environment had become tough, given how high stock market valuations were and how low bond yields had become.

GIC is well known for hiring many capable and intelligent people to form the ranks of their investment staff, so how concerned should ordinary investors be when reading such forecasts?

Let’s address the easiest problem first – stock market valuations. There has been much discussion in 2017 on the direction of the global stock market, given how it has broken out to new record highs. Should investors cash out and wait on the sidelines whenever this happens?

History has shown that stocks being at record highs do not give us any actionable intelligence. As the Singapore stock market has its roots only in the early ‘70s, we will look at the US stock market, which has a verifiable historical record dating from 1926. From records, there were approximately 320 months (representing 30 percent of all months) where the stock market reached a new record high. In the year following that record high, the market crept even higher 80 percent of the time! From this simple study, we can conclude that stock markets at record highs do not necessarily lead to poor returns.

A study conducted by Vanguard in October 2012 showed that popular stock market valuation ratios like CAPE (cyclically adjusted price-earnings), Debt/GDP, Normalised PE and the Dividend Yield model also had very little say in predicting future stock returns.

From their results, it appears that there is no strong relationship between high stock market valuations and future market returns. In fact, when studying annual returns from 1926, the stock market was positive 69 percent of the time.

So, whilst it is impossible to predict the short-term movements of the market, we know that in the long run, the stock market has provided investors a positive return, with the probability increasing to 100% if one has a holding period of 20 years or more.

This leads us to the inevitable question: what actually drives expected returns for stocks?

A simple way of valuing stocks is to calculate the future cash flows of the company which you intend to invest in, and then discount it in today’s dollars. The discount rate of the stock is the investor’s expected return. Every minute of every day, stock prices are set by the interactions of buyers and sellers who agree to transact at a price that both parties feel is advantageous to them.

Since we already know that the stock market has historically been positive nearly 70 percent of the time, it shows that buyers expect a positive return when they buy. If not, nobody would be willing to buy stocks. Another analogy would be – if you knew beforehand that you would lose money investing in a property, it is highly unlikely that you would make that transaction. As such, buyers of stocks, like other asset class investors, expect a positive outcome from their investment. Simply put, this is one of the main drivers of stock market returns.

What about the uncertain environment that GIC talks about? If you do not believe in the history of markets and have great reservations on investing in this current climate, what should you do? An easy option is to do nothing, and just wait for the so-called best time to roll along. However, the flip side is that you could be waiting a long time and possibly suffer the opportunity cost of watching markets climb upwards, hence missing out on investment gains.

In such instances, a very tried-and-tested concept of dollar cost averaging can work for you. You do not need to worry about where market prices are headed, but just phase in your investment in accordance with a fixed schedule, e.g. on a monthly basis. You buy a little bit less if stock prices are high, and you buy a little bit more if stock prices go down. Following this simple strategy relieves the stress of trying to time the markets and allows you to still be invested, albeit at a measured pace.

Another strategy to ensure that your investment portfolio holds up well, even if the market tanks, is exactly what GIC prescribes: to build a resilient and diversified portfolio.

Unfortunately, the ordinary investor cannot access the complex investments that GIC holds, such as private equity and infrastructure assets. We believe that the best and most simple way for an individual investor to build a diversified portfolio is to invest in a globally-diversified stock portfolio through low-cost funds and indexed vehicles.

How do you build resilience? Investors commonly chase returns without knowing the level of risk they are taking. It is only when they suffer losses in a market downturn that they panic and sell, thus permanently locking in those losses.

Thus, you need to understand how much your current portfolio could potentially lose, using a statistical risk metric known as Value-at-Risk (VaR). Just knowing this simple metric helps you identify a suitable asset allocation which allows you to ride out market cycles.

In conclusion, new all-time highs in stock markets cannot definitively predict whether returns in the future will be good or bad. While returns are never guaranteed, investors always expect positive returns every time they invest, otherwise nobody would participate in the capital markets.

Since we cannot predict whether the stock market would go up or down, the best way to invest in a relatively stress-free manner is to combine well-tried concepts of dollar cost averaging, diversification and building resilience.

Choosing a portfolio with a VaR that is within your risk tolerance will help you stay invested and not panic during market storms. Finally, investing for the long term puts the odds on your side, helping you to achieve an optimal outcome, regardless of the current market climate.

#

(This is part of a series of articles that we have been writing for Singaporean investors.)

Previous
Previous

Understand That Economic Numbers and Market Returns Are Not Always Related

Next
Next

Choose a simple, diversified portfolio for long-term investment success