What Goes Up, May Not Necessarily Come Down
Gravity explains the motions of the planets, but it cannot explain who sets the planets in motion.
― Isaac Newton
Around 350 years ago, history was made when a young Isaac Newton discovered the law of gravity — he was sitting under an apple tree and was hit on the head by a falling piece of fruit. Does the law of gravity have any bearing on financial markets?
After going through a soft patch in September and the first half of October, global markets have reached all time highs again, defying concerns about the ongoing COVID-19 pandemic which doesn’t seem to be abating. Financial commentators love to raise investors’ emotions by suggesting that Isaac Newton’s laws of physics also apply to financial markets — that what goes up must come down. You don’t have to look too far to read of headlines, erroneous or otherwise, proclaiming the end of the bull market year in and year out:
It is common to feel both happy and sad with record-high stock prices. You are pleased to see your existing investments rise in value, yet cannot escape the fear that these higher prices somehow mean a dramatic fall in the future. As such you may be reluctant to make new purchases since the traditional “buy low, sell high” saying suggests putting your hard earned money to stocks at high prices is a surefire recipe for disappointment.
Unlike the apple which fell on Newton’s head, shares are not weighted objects kept aloft by nature, fighting the force of gravity. Shares are a stake on companies’ earnings and dividends. Employees in these companies go to work every day seeking projects that appear to offer profitable returns on capital while providing goods and services people desire. Although some new ideas and the firms behind them end in failure, history offers plenty of evidence that investors around the world can be rewarded for the capital they provide to these companies.
Investors should treat record high prices with neither excitement nor alarm, but rather indifference. We should expect stocks to always give us a positive return. Otherwise, why invest in stocks in the first place? So with that in mind, we should expect stocks to reach a record high nearly half the time.
An analysis using month-end data over a 94-year period ending in 2020, the S&P 500 Index produced a new high in ending wealth in more than 30% of those monthly observations.
Even if you had bought stocks at all-time records, you would have generated similar returns over subsequent one-, three-, and five-year periods to those of a strategy that purchases stocks following a sharp decline, as the diagram below shows.
A graphical look at global stocks (in SGD) below shows that stocks regularly hit all time highs (in green shaded areas) over the past 25+ years - despite undergoing two significant bear markets in the dotcom bubble and 2008 GFC.
Because of what we hear, we unfortunately have become conditioned to think that after the rise must come the fall, which tempts us to meddle with our investments. The data shows that you need not do anything in order to get a better investment outcome. Take comfort from the fact that share prices do not fight the forces of gravity, neither do they commonly “revert to the mean” as many commentators tend to dwell on. If you need a second opinion on your investments, come and speak with us.
