In this article, we point out that investors need not sell everything to cash and assume a sell-off every time markets make new highs. Empirical data suggests that the current high price of stocks has no bearing on future performance, and in fact the probability of markets ending up higher is very good.
For us to determine whether a small correction (which is normal in any stock market cycle) is a precursor to something more ominous is dependent on whether the economy is headed for a recession or when financial stress levels are high. Currently, neither scenario is apparent. As such, we advise investors that although investing involves risk, one should invest with the expectation that you can make a profit on your assets in the future. That probability is high, given that markets go up 70% of the time. Corrections are part and parcel of investing, and at present, any sell-off can be taken as an excellent buying opportunity. So, sit back, invest and relax, and put your money to work!
Global equities broke out of their 15-year trading range in Dec 2016 and have continued to set new records this year. It has been a very painful trading range for investors, leading many to question the purpose of investing in capital markets and whether the system had been broken (Fig 1).
The painful part for investors was that many piled into the market at the end of 2007 near the peak, and have had to wait for 10 years to breakeven. Unfortunately, many gave up hope and sought refuge in bank deposits or other asset classes like property.
We continue to remind investors that markets work in cycles. There have been many periods in the past where markets were stuck in a sideways trend as a result of a secular bear market. However, the main takeaway is that after a secular bear, there is always a secular bull where investors are rewarded for sticking to their game plan and not deviating.
Fig 1: MSCI World Index (Global Equities) in SGD Currency Since 1980.
A big question on many investors’ minds now is whether the market is primed for a big contraction, given current prices of stocks. Disregarding the financial media and news pundits who often tout their opinion as fact, let’s take a look at the hard evidence instead.
We have taken data about the US Stock Market, which has the longest history of data (since 1926) and acts as a proxy for the global stock market (comprising 55% of the world equity market). The diagram below shows that whenever the stock market has made a new high, over the next 12 months the stock market has provided a positive return 80.5% of the time! (Fig 2). That just means that we are more likely (4 out of 5 times) to experience markets going higher than markets going lower.
As such, the key takeaway from this is – markets being at an all time high gives us no actionable intelligence on whether the market will go up or down in the near future.
Fig 2: S&P 500 Total Return Index Highs: 1926-2016 (Percent of Months With Positive Return Over the Next 12-Month Period)
Positive Expected Returns
The more important question that investors should be asking instead is: should I expect a positive return when investing in stocks?
The answer is YES! Let’s just use a simple analogy with Singaporean’s favourite asset class, i.e. property. If you knew that you were going to lose money when you invested in that property, would you do it? Obviously not, and it is the same with stocks. Nobody would buy it if they knew it was a losing outcome.
Let’s take a look at empirical data again, this time showing the returns of the equity market over money market assets (Fig 3). You will notice that it is hard to predict which year will be positive and which year will be negative. What is significant, however, is that over the last 86 years, there have been 59 positive years for the stock market and only 27 negative years. The stock market has spent 70% of the time generating positive returns. In addition, the arithmetic average of stock market returns (including all the negative years) is around 8% over the long term. So, probability favours the disciplined investor who sticks to the investment plan and does not deviate.
Fig 3: Yearly Observation of Stock Market Premium over Money Market Assets (T-Bills)
Now that we have established that a stock market high has little bearing on the direction of stock prices in the future, let’s discuss what investors should do if they face a correction soon.
Can Trump Make America Great Again?
Since winning the US Presidency, Donald Trump has been on the receiving end of many negative reports. We do not want to get sucked into a big political debate, but would rather want to take a look at his broad campaign promises to see whether they have any chance of lifting the American economy higher or are just flat promises. Whilst detractors have continued to lambast the lack of details for his plans, a look at the fiscal stimulus from his broad plans clearly does show that it has the ability to boost growth (Fig 4). No wonder the markets have rallied ahead of the news and are trying to price in the possibility of such positive moves.
Fig 4: Potential Positive Fiscal Stimulus Effect From The Trump Agenda
Coupled with the boost that the stimulus would bring to the American economy, there are very few signs of a recession over the next 12 months. The economic expansion since 2009 has been one of the slowest on record, and because of this, the economy is still operating below its potential and is nowhere near being overheated (Fig 5).
Fig 5: American Economy is Still Nowhere Near Overheating But Has Been Expanding More Rapidly Recently
With the Trump stimulus and the economy getting underway again, it remains only a matter of time before the Federal Reserve hikes interest rates again.
We do not know nor want to predict how many times or how much they will raise this year. We are only concerned with whether the Fed’s monetary policy becomes too restrictive and starts to choke the asset classes we are investing in.
For now, despite the Fed starting on its tightening cycle, the real monetary policy in the US continues to remain accommodative, and this is positive for investing in growth and risky assets like stocks (Fig 6). There is still room for more policy tightening before it becomes a headwind for stocks, so investors need not overly worry at this point in time.
Fig 6: Monetary Policy Continues To be Bullish For Stocks And There Is Still Room for Tightening Until Policy Becomes Too Restrictive
What Should I Do During a Sell-Off?
What we have described in this article so far paints a rosy picture for stocks, but don’t get complacent as yet. Investing involves taking risk, and as news and events occur throughout this year, market prices will move up and down to try to incorporate all the relevant positive and negative data.
Again, we cannot forecast when a correction will occur or the magnitude of such an event. There is no doubt that we will see a correction of some sort this year. The more important point for investors to ponder will be: can I put my money to work during the correction, and if so, how would I know if this correction is not something more ominous?
To show our investors that corrections always occur, the chart below shows the number of days the market goes through without a 5% correction (Fig 7). The current rally is currently the longest in the past 10 years – of which there have been many occasions where the market continually gets hit with a 5% correction. Without trying to be predictive again, we really do not know how long the market can go on like this, but it’s quite likely that we could see a 5% correction sometime this year.
Fig 7: The Black Triangles Denote The Number of Days the Market Has Gone Without a 5% Correction – Currently The Longest Now In the Past 10 Years
On to our second point – when do we know whether this correction will turn into something more serious? First, we have our proprietary Risk Matrix to tell us whether the current financial markets are stressed. If markets are stressed, then the likelihood of a big sell off (more than 20%) is quite high. The only other instance when the market has a big sell off is during economic recessions. Our discussion earlier in the article shows that there are very few signs that point us to a possible recession in the near term.
Using open source data which clients can refer to, we take a proxy to our Risk Matrix using the Federal Reserve’s Financial Stress Index. Current levels of financial stress is very far below the threshold (Fig 8). With the possibility of a recession quite far off and as long as financial stress does not increase, investors can take every little market sell-off as an excellent buying opportunity.
Fig 8: Current Financial Stress Levels Are Benign And Suggest That Any Market Corrections Would Not Lead To a Big Bear Market
Investors buy stocks with the expectation that they can make money from it. However, always remember that investing involves taking some risk which implies that there is no guarantee you will experience a positive return in the future. Whilst there have been instances where the return on our capital has not been positive (especially in the last 15 years, if you had invested near the peaks!) stock markets have acted like this in the past, and investors need not lose heart nor sleep over this. Continue to stay disciplined, stay the course and as long as there is little sign of financial stress or a recession on the horizon, take any correction as a buying opportunity.