The Stock Market Is At All-Time Highs – Now What?

Highlights

• All of the three major domestic market indexes ended at record closing highs this past Monday.

• There is a natural tendency to become nervous about owning stocks at market highs.

• History suggests that a market high is not a good reason to sell stocks.

“I can calculate the motion of heavenly bodies, but not the madness of people.”

     – Sir Isaac Newton

Year to date, the Dow Jones Industrial Average has closed at record highs on 12 separate occasions.  The most recent (as of this writing) was November 18, 2019, when the Dow, S&P 500 and Nasdaq all ended the day at records in response to investor optimism for a U.S.-China trade deal, although conflicting news reports have recently caused stock prices to waiver.

Looking at a longer time frame, the S&P 500 is up more than 468% since March 9, 2009, according to The Leuthold Group.  The long-running bull market has triggered increased skepticism among some investors regarding the prospects for equities.  The concern can be traced, in part, to the support the stock market has received from the Federal Reserve’s low-interest-rate policy, which may have run out of steam, and record high levels of debt, which may not be sustainable.  CNBC reports that U.S. corporate debt levels have reached $6.5 trillion and the national debt has eclipsed $23 trillion. 

Perhaps, however, a bigger cause for the indigestion that some market participants have been feeling as of late is our natural reluctance to overpay.  Everybody likes a bargain, myself included.  In fact, I’ve instructed Mrs. Commentator that my tombstone should read “He never paid retail!”

Surprisingly, odds are the stock market will go higher following an all-time high. 

The momentum factor provides at least a partial explanation for this market tendency.  As I discussed in this earlier post, momentum factor refers to the tendency for stock prices to continue to head higher during bull markets, and vice-versa.  The premise underlying the momentum factor is investors tend to over-react to positive (and negative) news about the economy, the markets, or individual companies.  This irrational exuberance (or pessimism) often causes prices to move up (or down) more than pure logic would dictate. 

Unfortunately, there is also a dark side to the momentum factor.  Sooner or later, rational thinking will take hold, at which point a sharp reversal can occur.  For example, on September 20, 2018, Vanguard’s Total Stock Market ETF (VTI) closed at $151.31, which was its high for the year.  On Christmas Eve, the closing price had fallen to $119.70, a drop of over 20% (the classic definition of a bear market). 

Equally important to recognize is that rallies sometimes follow a momentum crash.  Continuing with our example, last Friday (November 22nd) VTI closed at $158.14, a 25% increase from Christmas Eve.  This sudden reversal in the price of a security or the direction of a market is referred to as a “whipsaw” and, as explained here, can take a big toll on pure momentum investment strategies.

So, what should you do if you have cash to invest?  The first step is to assess your investment horizon and risk tolerance.  Are you committed to stick with stocks for the long term (i.e. 5 years or more)?  Will you be able to honor this commitment should a bear market take hold?  If you answer “yes” to these questions, I believe the best course of action is to pay little attention to market levels when deciding whether to buy (or sell) stocks.

On the other hand, if you have a shorter investment horizon, or might not be able to stay calm and carry on in the face of a 20%-40% drop in stock prices, then consideration might be given to investing in stocks in equal amounts in monthly installments over a 12 to 24 months.[1]

The takeaway from this discussion: It’s a bad idea to try to time the market based on a single piece of data, such as market level.  Rather, investors should use academically sound, rules-based investment strategies to direct their investment decisions.   

Thank you for reading,

Mr. Market Commentator

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[1] This method for entering the market is referred to as “dollar cost averaging”.  More information on dollar cost averaging can be found here.

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