Record High, Record Worries

Key Takeaways

• A lot has been said in the financial media after the S&P 500 and Dow made new record highs.

• But this should not be surprising, stock prices in aggregate are expected to go up over time as the companies we invest in are expected to increase their cash flows from profits, and consequently increase earnings.

• The US and Global stock market will hit all time highs frequently. If you are worried about long-term losses, then a properly diversified and constructed investment portfolio can reduce volatility during those times to minimise losses and maximise returns.

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One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.

— William Feather

There has been quite a lot of fanfare recently in the financial media after the S&P 500 and Dow (both indices which track US large-cap stocks) made a new record high.

• S&P 500 reaches new record as US stocks surge
  — The Straits Times

• Stocks are at record highs, but things will only get harder from here
  — Wall Street Journal

• S&P 500 hits record intra-day high driven by chipmakers, megacaps
  — CNA

• Dow closes above 38,000 for the first time
  — CNN

Investors can’t be blamed if they rejoice a little, but the truth is, there really isn’t anything special about stocks surging higher than before. Unlike a sporting record that was beaten, it would mean that an act of impressive athleticism, determination, and training has occurred; the new record may or may not be beaten for quite some time again. However, for stocks, they are meant to beat their previous records all the time.

Why is this so? We expect stock prices in aggregate to go up over time. Most explanations on why stocks go up often attach an overly simplistic view to it — that it’s simply from pure demand and supply. However, there is an underlying economic value to stocks — as investors we expect the companies we invest in to provide increasing cash flows from profits over time. With increasing earnings, we then expect stock prices to continue to rise as well. This is similar to the expectation of property investments — it’s not only demand and supply but about the underlying economic value as well.

However, when stocks go up to high(er) levels, worries abound. There is a reason for increased investor apprehension whenever market records are set. For one, the traditional “buy low, sell high” mantra goes against allocating capital to investments when markets are at highs. Second, financial journalists periodically stoke this fear by suggesting the laws of physics apply to financial markets — that what goes up must come down.

• “The Risk of Mean Reversion Has Stocks Staring at a Profit Squeeze”
  — Bloomberg

• “The Stock Market, After Soaring for Years, Returns to Earth.”
  — NYT

• “Weird Science: Wall Street Repeals Law of Gravity”
  — Barron’s

If you know and expect stocks to have a positive expected return over the longer term, then reaching records quite frequently is exactly the outcome you should not only embrace, but expect. A quick glance at the price chart of the S&P 500 index since 1981 shows that except the “lost decade” period after the dotcom bust till after the 2008 GFC, the US market has hit record highs with some regularity (highlighted in yellow in the chart below).

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A similar story can be seen for global stocks as well — where global stocks have hit all time highs regularly except for the period after the dotcom bubble and 2008 GFC.

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A look at these charts may leave you thinking — what if I go through a long period with lower than expected equity returns like what happened in the 2000s?

That’s where asset allocation comes in. A properly diversified and constructed investment portfolio with a well thought out mix of different assets helps to reduce volatility and also maximises returns especially when markets are coming down. The chart below shows just that — an asset allocation portfolio (in blue) hits record highs more frequently than global stocks (in orange) during the period when stocks were not doing so well.

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Reaching a new high doesn’t mean the market will then retreat. Whilst there have been periods in the past where investments could be priced below their previous highs for some time, it is hard to time these exit points well. A better way to manage these periods would be to have a robust portfolio with proper risk mitigation which we have implemented over time for client portfolios.

For more information on how to navigate the current investing and market environment, come and speak with us here.