The End Of The Rally?
Key Takeaways
The stock market has been rallying for the past 7 months. The uninvested are asking ‘Should I get in?’, the invested are asking ‘Should I get out?’
New highs for stocks are not uncommon. Statistically for nearly the past century, new highs happens in the US markets 1 out of every 6 weeks.
Following each all-time high, less than 1 out of 10 times has the market ended negative 1 year out. When you extend the time horizon to 5 years or more, the number of times the market has ended negative drops to 0.
History shows that reaching a new high doesn’t always mean the market will then retreat. As investors, we should celebrate that the market is doing well and providing a return on capital above inflation.
Every ending is a beginning; We just don’t know it at the time.
— Mitch Albom
The equity market rally that started in Nov 2023 has gone on for seven months now. If you have been on the sidelines, you may be wondering when is the correct time to get in. On the other hand, if you are fully invested, then you may be wondering when the inevitable correction would happen, and what its potential magnitude could be. And that’s something that we assess and look at about every day.
Stock markets that had been lagging (e.g. China) have recently started showing signs of life; on a broad basis, many global stock markets are hitting new highs as the news report below highlights:
With such news, it is natural to wonder whether now is simply a great time to be in stocks—or conversely, do record levels portend an upcoming tumble? A look at history should help alleviate such concerns.
New highs for stocks are not uncommon. Since 1926, the US market has ended the week on a new high for 933 out of 5,099 weeks, slightly more than one out of every six. Periodic record setting should be expected for an asset class with high historical average returns. Interestingly, the average return for weeks following these new highs was 0.26%— slightly higher than the average return of 0.22% across all weeks.
In the same way, property prices also exhibit similar characteristics. Historically, property has gone on to hit new highs on a regular basis—there is no way you are finding any home in Singapore at 1980’s prices. However, property does not have a similar type of fanfare as prices are slower moving. In addition, investors celebrate when new highs are hit, as opposed to stock investors, who turn anxious instead.
Many of us can be guilty of waiting for the other shoe to drop whenever something has gone well. Fortunately, we don’t have to view markets that way. As long as investors demand positive returns in exchange for holding stocks, a new market high doesn’t mean the market is automatically going to snap back. It may very well mean that things are about to jump forward instead.
Numbers, Stats, and History
Many investors may think a market high is a signal that stocks are overvalued, or that they have reached a ceiling. Using a similar long-dated dataset with US equities, the average returns for the S&P 500 Index 1-, 3-, and 5-years after a new market high are similar to those after months that ended at any level.
When we look at the probability of corrections that the market encounters after reaching this “ceiling”, you will be surprised to find out that it is actually quite small as the diagram below shows. Following each of the over 1,250 all-time highs since 1950, the market has finished negative only 9% of the time 1 year out. And when the time horizon is extended to 5 years or more, has not ended negative.
Overvalued?
What about valuations? There are some commentators who are highlighting stretched valuations as a sign as this market rally is soon to end—citing the incredible run of US tech stocks as an example. The chart below shows the earnings yield of the global stock index—which can provide some insight as to whether this is true.
Earnings yield is basically an inverse of the Price/Earnings ratio—where earnings per share is divided by current stock price. So an earnings yield of a smaller number means that it is more expensive compared to an earnings yield of a larger number. Present day valuations are just below long term averages—which means that stocks could be slightly overvalued. However, this overvaluation does not mean that we will be facing a correction any day now.
You can see that the market was way more overvalued during the dot com bubble of the 2000s than it is now. Overvaluation can also correct itself such as during the periods of 2004, 2010, and 2018 as companies started to experience increased earnings and led to the resumption of the bull market.
As such, history shows that reaching a new high doesn’t always mean the market will then retreat. In fact, stocks are priced to deliver a positive expected return for investors every day, so reaching record highs with some regularity is exactly the outcome one would expect. As investors, we should celebrate that the market is doing well and is functioning as intended—providing a return on capital above inflation.
Of course we should not be blind to the possible road bumps ahead, as investing is not always smooth sailing. This is where proper asset allocation, and risk management measures such as our Risk Matrix come into play to ensure that your investments are robust and can withstand the inevitable volatility that will come.
If you would like to find out more about how to efficiently and invest effectively during market highs or when prices are running up, come and speak with us.
