In the past several weeks, as the market has been hitting new highs, we have received several questions about what this means for investors. A common viewpoint is that if the stock market is hitting all-time highs, this must have implications about where the market is headed in the near future. The last time markets hit historically high levels, it was as part of a financial bubble which led to a crash and subsequent financial crisis. This leads to the very reasonable question “Should we move money out of stocks now?” One way for us to answer this question is to examine market history. Looking at what has happened in the past is an extremely useful exercise because it provides context from which we can make informed decisions about the future.
Recently this notion (that examining market history can be instructive when trying to understand what the future might hold) has been under fire by several pundits who proclaim “It’s different this time” and therefore the past is meaningless. Think about how this same line of reasoning would be received by the medical profession. Can you imagine a world of doctors who all proclaim “This time it’s different,” when treating a sick patient and simply choose to ignore the medical research on the patients illness? In the medical field this is called malpractice. Yet somehow, in the world of finance and investing, the same people who ignore market history can be called by the name “maverick”, “contrarian”, or “market guru”. A more appropriate name for such professionals might be charlatans.
So what does market history say about the market reaching new highs as it relates to future performance? One recent study conducted by the Dimensional Fund Advisors Research Group explores this question. In the study, they covered the S&P 500 Index using daily data from July 1962 to the present, and looked at what has occurred after the index reached a new all-time high.
The findings are summarized in the table below. After each new high, they looked ahead to find out what happened to stock prices 1, 3, 6 , and 12 months afterwards, and then tabulated the percentage of the time that the index level was at or above the level it had reached when it had set the new high.
As a comparison, the table also includes the percentage of the time where the index is higher after any previous level (not just after a new high was reached).
As the table shows, for each of the four horizons considered, the sample includes the same 718 days on which the S&P 500 closed at a new high in the observation ranges shown. Of course, this result should be somewhat expected since the market is, on average, going up over this period. Notice that the numbers in each case are quite similar. Thus we can conclude that the relationship between new market highs and future performance is nearly the same as from any other point in time.
Why don’t these numbers reveal more? Historically speaking, we find that the best (though not perfect) long term indicator of a stock market performance is not the market reaching new highs. Instead, the best indicator is how “expensive” or “cheap” stocks are. This can easily be determined by the price to earnings ratio (P/E).
Let’s take the S&P 500. In December of 1999, the S&P 500 was trading at a P/E ratio of 35.5. Historically, from 1962-2013 the S&P 500 has averaged a P/E of 18.64. From this, we can tell that in 1999 the S&P 500 was “expensive” or overvalued relative to historical levels. We also know that, in terms of performance, the next 10 years for the S&P 500 were not very good.
Today, although the market is reaching new highs, the P/E for the S&P 500 was 17.23 as of May 20, 2013. This indicates that the market is priced very close to normal. Stocks are neither cheap nor expensive. Such a level is indicative of “normal” returns for the foreseeable future. Of course, year to year is impossible to predict, but over a 10 year time frame, it is reasonable to expect that returns would be close to historical average based on this method.
This is due to the fact that while the news is not great and there are many possible threats around the globe, fundamentally stocks go up over the long run because corporate earnings increase. I don’t know what force (over the long run) would prevent corporations, businesses, and individuals from around the world from pursuing growth. Indeed, it would be a very difficult task to halt the economic incentive that fuels innovation and growth – which in turn means higher corporate earnings – which drives stock prices up over the long run. In the short run – it is easy to get distracted by the noise.