Actionable Information

With the S&P 500 and other US stock market indices hitting new all-time highs and the Dow Jones Industrial Average (DJIA), an index of 30 US based stocks, nearing the 20,000 level for the first time, should this cause a change in your investment strategy?

History tells us that a market index being at an all-time high generally does provide actionable information for investors. History and US stock market data would recommend that as a long-term investor, you maintain your appropriate stock market allocation, even though markets may be at highs.

As financial advisors, we recommend a globally diversified portfolio of both US and International stock funds be held. For purposes of this essay, information on US stock markets is used, but the same logic can be applied to International stocks.

For evidence, let’s look at the S&P 500 Index for the last 90 years. As shown in Exhibit 1, from 1926 through the end of 2016:

  • Over the 1,081 months during the period, 319 months, or 29% had new closing highs.
  • After a new monthly high, there were positive returns 80.5% of the time over the next 12 months.
  • For all 1,081 months, there were positive returns 74.7% of the time over the next 12 month period.S&P 500 Total Return Index Highs 1926-2016 chart

 

While this data does not help us predict future returns, especially in the short-term, it validates the importance of remaining invested over the long-term. It shows that the S&P 500 has been higher 12 months later around 75% of the time over the past 90 years. Staying invested and not making changes based on your emotions and current news events increases your likelihood of long-term investing success.

Many studies document that professional money managers have been unable to deliver consistent outperformance by outguessing market prices. In the end, prices set by market forces are difficult to outguess. This is why we have adopted, and consistently adhere, to our investment strategy of using index-like mutual funds.

It is reasonable to assume that the price of a stock, or the price of a basket of stocks like the S&P 500 Index, should be set so their expected return is positive, regardless of whether or not that price level is at a new high. This helps explain why new index highs have not, on average, been followed by negative returns. At a new high, a new low, or something in between, expected future returns are positive.

So while expected future returns are positive, that does not help us know the future direction of stocks, especially in the short term. Historically, however, the probability of equity returns being positive increases over longer time periods compared to shorter periods. Exhibit 2 shows the percentage of time that the equity market premium (defined for this purpose as the Total US Stock market, over the short term US Treasury bill return) was positive over different rolling time periods going back to 1928.

Historical Performance of Equity Market Premium over Rolling Periods

 

When the length of the time period measured increases, so does the chance of the stock market premium being positive. As an investor’s holding period increases, the probability of a negative realized return decreases. This is why it is important to choose a level of equity exposure that you can stay invested in over the long term.

We can certainly not predict how the stock market will do in the next few months or even the next few years. We know it is normal for there to be ups, as well as regular declines of 10% or more within a year, even if a year turns out to be positive (like 2016). However, we remain rationally positive that over the long-term, you will benefit if you remain invested in a diversified portfolio which is appropriate for your personal situation.
Source: Dimensional Fund Advisors LP

 

Disclosure A: The S&P data is provided by Standard & Poor’s Index Services Group.  For illustrative purposes only.  Index is not available for direct investment.  Past performance is no guarantee of future results.

 

Disclosure B:  Information provided by Dimensional Fund Advisors LP.  Based on rolling annualized returns using monthly data.  Rolling multiyear periods overlap and are not independent.  This statistical dependence must be considered when assessing the reliability of long-horizon return differences.  Fama/French indices provided by Ken French.  Index descriptions available upon request.  Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.  Indices are not available for direct investment.  Past performance is not a guarantee of future results.

 

 

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published. Required fields are marked *