The stock market faltered in the spring but has since returned to near-all-time highs. Yet, the real economy is in recession. This leaves many investors wondering whether the stock market is disconnected from reality, and whether we’re “due for” a crash.
Despite the seeming disconnect between the stock market and the economy, the historical data suggests that long-term investors would be prudent to maintain focus and stay invested.
From its peak in mid-February through mid-March, the stock market (S&P 500) dropped by nearly 30 percent. Since that trough, the market has recovered to new highs. The S&P 500 hit an all-time high in late August, before falling in September, but recovered again in the last few weeks.
Let’s break this question down of whether to invest, or stay invested, in light of recent positive stock market performance.
First, is the stock market divorced from reality? Second, can we learn anything from historical stock market data? Finally, what alternatives do investors have?
A break from reality?
First, a look at the question of whether the stock market is disconnected from current economic conditions.
The short answer is yes, but this is no different from any other time.
The stock market reflects the perceived value of future cash flows of companies. This means that stock prices reflect investor predictions about how much a company will make not just in 2020, but in 2021, 2022, 2023 ... and so on. Therefore, the price today is necessarily divorced from current conditions — it reflects the consensus view of the future, which is inherently unknowable and likely different than the current state of the world.
Moreover, aggregate stock market data obscures some trends that make a lot of sense. Although the broader S&P 500 has returned to near-all-time highs, that trend has been driven by technology companies that have become more entrenched in our everyday lives during the coronavirus pandemic.
On the other hand, an index of airline stocks is still more than 40 percent below its mid-February highs. Many cruise line stocks are down more than 60 percent year to date and have not recovered at all, as compared with the broader market.
From 1980 through 2015, the S&P 500 reached an all-time monthly high 143 times. The average subsequent five-year return after those all-time highs was 12.2 percent per year.
During that same period, there were 69 months where the stock market was at least 20 percent below the all-time high. The average subsequent five-year return after those months when the market was “discounted” was 10.2 percent per year.
The data does not support the conclusion that you have to buy the stock market when it’s below an all-time high.
But, mathematically and logically, we know it is preferable to invest when the market is lower. So, let’s just say that we’re not comfortable with all-time highs and we want to wait for a downturn. That doesn’t make the job any easier.
How do we know when the bottom is? What is our signal? If the market falls 5 percent, is that enough? What about 10 percent? By the time the market falls 20 percent, you can bet it’s going to be harder to invest, not easier, because that would reflect a riskier economic environment.
The point is that there is no clear signal that guarantees higher future returns, and waiting on the sidelines can be just as difficult as being invested.
What is the alternative?
Finally, an investor must consider what economists call the “opportunity cost” of investing, or not investing.
In the early and mid-1980s, an investor could choose to buy safe, short-term government Treasury bills and get an interest rate of 8 or 9 percent. In the mid-1990s, this interest rate was about 5 percent. Even as recently as 2007, the three-month Treasury bill yield was near 5 percent. As of September 2020, that interest rate is 0.1 percent. Egad!
Keeping money in cash on the sidelines may feel comforting, but the expected return on that cash is next to nothing, and the opportunity cost of doing so may end up being significant.
What about real estate? Many investors prefer to buy real estate to avoid the perceived danger of the stock market. However, housing price indices indicate that aggregate home prices are also at an all-time high.
Moreover, going back to 1980, the long-term investment return on housing prices is less than 4 percent per year. It’s not a bad alternative, and it probably feels good to hold physical property, but it’s hardly a slam dunk as compared to investing in stocks and bonds. Not to mention the ongoing time and dollar cost of owning physical property.
What about gold?
Many investors have been flocking to gold as a “safe haven” investment alternative to stocks and bonds during this economic downturn. As a result, gold has performed very well this year. It is up about 25 percent. But, again, the gold price is near all-time highs and the long-term future performance of gold is no guarantee.
All of these alternatives are an important part of a broadly diversified portfolio. It’s prudent to hold money in cash. Owning your home and real estate can be helpful for long-term growth. Gold can be an important portfolio diversifier. But, at the end of the day, a broadly diversified portfolio should continue to hold stocks and bonds.
What to do?
Investors should hold a portfolio of investments that reflects current household financial circumstances and tolerance for risk. For recent retirees, this may mean modestly adjusting the risk profile of the portfolio, but by no means does it mean bailing out of stocks because the market “seems” too high.
For investors in a broadly diversified portfolio that reflects current circumstances and risk tolerance, a high stock market should not be a trigger for significant changes, regardless of current economic conditions.
For people sitting on cash, it can be very difficult to get invested, but establishing a plan and sticking to it will be helpful in getting invested over time.
While you may choose to invest everything at once, you can also choose to gradually invest into a broadly diversified portfolio. There is no evidence that market highs and lows can be timed, but this approach may offer some behavioral benefits.