As far as economic and investment news goes, momentum has been a powerful force and your 2017 returns has benefitted.
The S&P 500 Index of large U.S. stocks has reached a new all-time high at some point in 19 of the past 20 months.
With many companies already posting record profitability, U.S. corporate tax rates have been lowered. This could further boost profitability, investment in research/development, dividends, or maybe even employee salaries.
International stock markets posted even better returns than the U.S. during 2017 as the declining value of the U.S. dollar increased returns in foreign currencies.
The MSCI World Index, representing nearly all publicly traded stocks, has posted 15 consecutive months of positive returns, powering past the previous longest streak of 12 months in mid-1980s.
Economic conditions have improved in the U.S. and Europe. Emerging markets are booming. Inflation is low. Unemployment is low. Collectively, employers have added jobs in the U.S. every one of the past 86 months. Interest rates have risen but remain attractively low for individuals and companies interested in financing purchases through debt.
It has been 102 months since the last U.S. economic recession. The average time between recessions since 1900 is 47 months.
Too good to last?
You might be tempted to look at these results with a viewpoint that returns have been too good for too long and something has to give. Don’t be too sure. This is the Gambler’s Fallacy: assuming there is a predictable pattern.
The S&P 500 has posted 20+% gains in 33 calendar years since 1928. The average return in the following year was 10.46%. Positive returns followed 68.75% of the time. We haven’t had back-to-back 20+% gains for U.S. stocks since 1995-1999.
Of course, there are certainly reasons to be concerned about future returns. Stocks appear to be richly priced. “What I’m concerned about is valuation,” said Yale endowment manager David Swenson. “I think when you look at pretty much any asset class anywhere in the world, it feels expensive.”
Pair expensive prices with lack of volatility and it may create complacency and set the stage for future fragility as investors ignore building risks. The largest 2017 intra-year decline for the S&P 500 was 3%. Since 1980, the average peak intra-year decline is 14%. Volatility is overdue.
Charles Schwab’s Chief Investment Strategist, Liz Ann Sonders, tracks 13 different measures of U.S. stock values. Of the indicators, three place stocks in “very expensive” territory, five are just plain expensive, two are mildly expensive and three are inexpensive. All three of the inexpensive indicators are in relation to interest rates and bond yields. Stocks are still more attractive than bonds. But stocks relative to historic measures all point to this being an expensive time to buy more (stocks) at these prices.
However, measures like these are not good predictors of when the direction of market returns will pivot. They have been strong indicators of longer-term average annual returns over the next several years. Plan for lower returns, but know that the tipping point is hard to define.
The point of the market is to set new all-time highs
While forward returns could be underwhelming, the likelihood is that new highs will continue to be set over time. In 2017, the S&P 500 set new all-time high marks more than 70 times.
Research from Dimensional Fund Advisors shows that 30% of all months since 1926 have featured a new all-time high for U.S. stocks (S&P 500 and precursor equivalents). A month later, 64% of all months with all-time highs pushed to a new higher mark. One year later, 81% of all months with all-time highs pushed to a new higher mark. Five years later, 84% of all months with all-time highs pushed to a new higher mark. Ten years later, 92% of all months with all-time highs pushed to a new higher mark. (Outliers were coming out of the Great Depression and the Tech Wreck of 1999-2000).
Therefore, even if you were the world’s worst market timer and only invested new money at new all-time high marks, as long as you were a long-term investor, you still saw your money grow, not as much as it could have if you invested some during periods of lower returns (“buy the dip”) but grow nonetheless.
Even if stocks are overpriced and a negative catalyst could pivot their direction, keep in mind that bear markets have historically been small compared to periods of growth.
The graphic below from First Trust shows the size of bull market periods relative to bear markets for U.S. stocks since 1926. (NOTE: Click on image for larger version.) Psychologically, bear markets are difficult. Human nature causes us to weight negative events at two times the impact of positive events. So, these orange declines feel much worse than they look.
The ever-present potential for negative returns are exactly why almost all investors should hold some diversifying assets to manage risks and keep money needed to cover short term expenses (1-3 years) away from exposure to stocks. Aside from that, manage fees, be tax efficient and understand where the guardrails need to be in your financial plan, and you’ll likely build and maintain financial security.
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