Actionable Information

With the S&P 500 and other broad US stock market indices hitting new all-time highs, should this cause a change in your investment strategy?

Given the strong performance of many US and International asset classes during 2017, the information below is even more relevant today than it was last January, when we originally wrote this blog post. We updated it as of the end of 2017. The message still applies!

The Dow Jones Industrial Average (DJIA), an index of 30 US based stocks, was close to 20,000 for the first time in early January, 2017. The DJIA increased to almost 25,000 by the end of December, 2017. The S &P 500 was around 2,250 in early 2017 and increased to almost 2,700 by the end of December, 2017.

Should this cause a change in your investment strategy?  Should you be getting out of stocks?

History tells us that a market index being at an all-time high generally does provide actionable information for investors.  As the date below shows, all-time highs are generally followed by even higher levels in the future.  History and US stock market data would recommend that as a long-term investor, you should maintain your appropriate stock market allocation, even though markets may be at highs.  You should not be getting out of stocks.

As financial advisors, we recommend a globally diversified portfolio of US and International asset class stock funds, not just US stocks. For purposes of this essay, information on US stock is used, but the same logic can be applied to various asset classes and 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.

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 around 75% of the time 12 months later 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. And this data would be even stronger with the results of 2017.

Many studies document that professional money managers are not able to deliver consistent outperformance by making active picks and frequent trading. In the end, prices set by market forces are difficult to outperform. This is why we have adopted, and consistently adhered 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.

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. There was not a decline of more than 10% during 2017, so you should be prepared for such a temporary decline. It is normal.

However, we remain rationally positive that over the long-term, you will benefit if you remain invested in a globally diversified portfolio of asset class mutual funds, in an allocation 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.

 

 

 

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