Stacking Risk

Markets Are at New Highs: Is a Contraction on the Horizon?

Stacking Risk

After coming off of a strong performing 2016 and with certain indices, like the Dow Jones Industrial Average, at or near all-time highs, many investors may be wondering if a market contraction is on the horizon. Unlike many of the professional news pundits who use their “opinion” as “fact,” a good starting point in a discussion on price levels and expected returns is to do what we always do: look at the data.

From January 1926 to December 2016, there were approximately 319 months (29%) where the S&P 500 reached a new all-time high.[1] The percentage of subsequent 12-month (1 year) periods in which returns ended up being positive was 80.5%. In other words, we are more likely to experience a positive return over the next 12 months given the fact that we are at or near an all-time high than experiencing a negative return. What is also important to understand is that this isn’t a trend that solely pertains to months in which an all-time high was realized. In fact, the percentage of subsequent 12-month (1 year) periods in which we realized a positive return after any given month was 74.7%. What this suggests is that experiencing a new price level doesn't really give us any new insight on what we can expect to happen going forward, other than it is likely that returns realized are going to be positive. See chart below.

Why is this the case?

We always like to remind our readers that in any given transaction a willing buyer and a willing seller come together and agree on what is a fair price that is advantageous to both parties involved. If the market didn’t have an expected positive return at any given time, than a willing buyer wouldn’t decide to partake in the transaction. To give a more practical analogy, if you invested in a property where you were expected to lose money, would you do it? Of course not! Going back to the stock market, it seems very unlikely that the market, in aggregate, would invest money in the market if it were a losing proposition. 

This is really a “round-about” way of saying that there should be an expectation that returns going forward are going to be positive. That doesn’t necessarily mean that realized returns will always be positive. As Benjamin Franklin famously stated, “nothing can said to be certain, except death and taxes.”

If we look at the rolling 10-year performance of the equity premium (equities minus 1-month T-Bills) from 1926 to 2015, we see that there were twelve 10-year periods where the realized equity premium was actually negative. But you also see that vast majority of 10-year periods experienced a positive equity premium. See chart below.

Further, the odds favor the disciplined investor. Looking at the spectrum of 1-year rolling returns to 15-year rolling periods, we see that the percentage of periods where we experienced a positive premium increases from 69% to 96%.

While everyone can be excited about experiencing positive realized returns and reaching new market highs, it doesn’t necessarily give us any new insight about what markets are going to do in future. Based on historical data, we should expect the next 12 months to be positive, just like they have been after any given month in the past. Investing involves taking risk, which is based on the uncertainty around the future profits of capitalism at any given time. As news and events happen, market prices adjust to incorporate both the positive and negative information so that the expected return on our capital is positive. But risk means there is no guarantee. Although we have experienced periods where the return on our capital was not positive, the odds of experiencing a positive return dramatically increase the more disciplined we are. This is why IFA recommends that our investors buy and hold for the long term.

[1] Dimensional Fund Advisors. “New Market Highs and Expected Positive Returns.” January 2017.