A Stock Market Cycle and Investor Discipline

July 24, 2019 8:00 am

Every point in a stock market cycle brings its own emotional challenges for long-term investors. When volatility spikes, as it did in 2018, investors need to muster their intestinal fortitude and avoid the temptation to flee to cash. In times of extended market doldrums, as we saw in 2015-16 when stocks mostly moved sideways, investors must avoid the temptation to go looking for higher returns in risky investments that can lead to big losses.

Then there is the environment we currently find ourselves in – with most major market indices at or near all-time highs. When stocks push into record territory, no one other than short sellers are unhappy. Real Estate continues to look unstoppable as well. It is also worthy to note that interest rate yields and inflation expectations are at generational lows.

Source: Federal Reserve Bank of St. Louis, FRED Economic Data Period: January 1, 1964 to March 31, 2018; Source: Illuminating the Path Forward, Ross Stevens, Joshua Zwick, Randolph Cohen, February 2017, p 5.

But the enthusiasm is often tempered with anxiety about stocks being overvalued and poised for a fall. These fears are only enhanced by the endless stream of stories in the financial media highlighting analysts’ predictions of a looming downturn. These stories are often accompanied by suggestions that investors should “take some winnings off the table” and pare back their stock exposure. We even discussed some related concerns in a recent blog The 60/40 Investment Debate.

To better understand how long-term investors should view the future direction of the stock market, it’s helpful to revisit the past. A look back at some of the major milestones the Dow Jones Industrial Average has achieved through the years is insightful.

The Dow first closed above the 1,000 threshold in 1972. It cleared 2,000 in 1987, closed above 5,000 in 1995 and hit 10,000 for the first time in 1999. Several times along this journey, the Dow failed to hold its ground when it reached a milestone and pulled back. Stocks entered a long bear market in 1973 and struggled to emerge from it for the rest of the decade. The Dow also spent much of the 2000s trying to hold the 10,000 level, only to fall back during the bear markets of 2001-02 and 2008-09. But the Dow also frequently blew through other milestones without looking back, notably during the mid and late 1990s, as well as in recent years. The below chart for the period from 1995 to 2017 highlights the journey to new milestones for the Dow:

Source: CBS Marketwatch research

The bottom line is that stocks hitting record highs and major milestones is not a clear indicator that a downturn is looming. Stocks can, and often do, keep soaring well after the conventional wisdom has decided equities are overvalued. And even if a downturn occurs, they are often temporary and shouldn’t dissuade long-term investors from putting money to work in the stock market. Of course, trying to predict market events in advance with long-term success is impossible. However, we do understand the importance of proper risk management and believe everyone should have a custom financial plan in place that is aligned with their investment strategy. This not only helps achieve one’s goals, but can provide a better way to protect their financial health for both their current and future needs. 

As usual, the Oracle of Omaha, Warren Buffet, had some keen insight on this topic. At a Forbes magazine conference in 2017, Buffet scoffed at those who are bearish about the future performance of the U.S. stock market. “Being short America has been a loser’s game, and I predict to you it will continue to be a loser’s game,” he said. He then made a prediction that the Dow would reach the 1,000,000 level within a century.

At first glance that seems incredibly bullish on Mr. Buffet’s part, but it’s worth noting that it would only require a 4% average annual gain in the Dow to reach the 1,000,000 milestone in a hundred years. And that’s really the whole point we are making: stocks are always plowing ahead, though rarely on a straight line. But the climb through record highs and major milestones is an inevitable part of the stock market’s nature, and those investors who let fears of stocks being “too high” are the ones who won’t be along to enjoy the ride.

A bit of esoteric-but-still-interesting research crossed our desk this quarter. The research firm TS Lombard conducted a study in which they separated out the returns generated in the S&P 500 from domestic (U.S. based) investors vs. the returns generated by overseas investors. The study covered the period from January 1, 2017 to April 24, 2019, and the results were striking.

The study found that nearly all of the 30% gain in the S&P 500 during that time period came outside of U.S. hours. When the U.S. exchanges were open, the S&P gained a mere 2%, with the rest of the gain coming after U.S. exchanges had closed. The spread was especially striking since the beginning of 2018, with the S&P 500 actually experiencing a 5.4% decline during U.S. trading hours, yet still posting a 9% gain for the period thanks to the bullishness of overseas investors.

So what can we glean from this research study? To us, it seems clear that overseas investors in U.S. stocks are focused much more on long-term fundamentals than they are on the short-term news cycle. Stocks in the U.S. tend to be more volatile while the U.S. exchanges are open because American investors are immersed in all the short-term noise surrounding the markets. How often have we seen the Dow plunge 100 points or more over a news report that momentarily panics the market, only to fully recover the next moment when the report proves false or less dire than initially believed?

While news about the U.S. certainly doesn’t end at our borders, it’s logical to assume that overseas investors aren’t as obsessed with every iota of new information that comes out during the U.S. trading day and are instead focused on finding the best investments for their money. And U.S. stocks have proven, time and again, to be an outstanding long-term investment.

Something to keep in mind the next time irrational anxiety grips the market and sends investors scurrying to hit the panic button.

As always, we appreciate our relationship with you and we are here to help.

Best,
Marc

Source:  Forbes; J.P. Morgan; Federal Reserve Bank of St. Louis; Bloomberg; Stone Ridge Asset Management. M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. As a fee-only firm, we do not receive commissions nor sell any insurance products. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. This blog has been provided solely for informational purposes and does not represent investment advice or provide an opinion regarding fairness of any transaction. It does not constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Any stated performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss. Charts and graphs provided herein are for illustrative purposes only. There are many different interpretations of investment statistics and many different ideas about how to best use them. Nothing in this presentation should be interpreted to state or imply that past results are an indication of future performance. Tax planning and investment illustrations are provided for educational purposes and should not be considered tax advice or recommendations. Investors should seek additional advice from their financial advisor or tax professional.

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This post was written by Marc Jimenez, CFA, CFP®

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