The Bittersweet Taste of a Bull Market

Eric Fry By Eric Fry
Macro Strategist, The Oxford Club

Market Trends

Delight, tinged with anxiety, seems to be the sentiment most investors are feeling these days. They’re delighted to participate in a stock market that is hitting all-time highs yet anxious about losing their gains if a big correction hits.

Such is the bittersweet taste of investing in a richly priced market that has not suffered a major correction in nearly a decade.

Not surprisingly, therefore, the most common question I hear these days goes something like this…

Do you think the market is going into a major correction soon? If so, what should I do about it?

I empathize with the spirit of these questions, but there is simply no good way to answer them.

For starters, I don’t have a crystal ball or an advance copy of next week’s Wall Street Journal. So I have no idea if the market will rise or fall tomorrow.

Secondly, every investor has a different risk tolerance and investment time frame. Investors with a long-term investment time frame can afford to pay almost no attention to the risk of a big bear market. But investors who are close to retirement cannot.

So in response to the question about what to do in a high-priced market, I’ll provide no answers whatsoever. Instead, I’ll offer two observations – one for short-term investors and one for long-term investors.

For short-term investors, I would simply point out that mathematics is not your friend. Based on most valuation metrics, the U.S. stock market has reached its most expensive level of the last several decades.

A high valuation does not necessarily mean that the market is doomed to implode, but it does mean that the market is unlikely to produce large gains over the next few years. A high valuation also means that the risk of large losses is not zero.

At least that’s the message from history. The chart below shows the latest readings on the so-called Buffett Indicator. (Warren Buffett once called this metric the “single best measure of where valuations stand at any given moment.”)

According to this “big picture” valuation gauge, the U.S. stock market is relatively expensive whenever its market capitalization climbs well above 100% of our annual gross domestic product (GDP).

Today, the U.S. market cap totals a whopping 150% of U.S. GDP, which is the highest reading this metric has reached during the last 42 years!

When stocks become this pricey, future gains are very hard to come by.

That’s a stone-cold fact.

As the chart below shows, a high reading on the Buffett Indicator tends to precede a long stretch of poor stock market returns, whereas a low reading tends to precede a long stretch of strong returns…

For example, in 2008, when the Buffett Indicator tumbled to less than 60% of GDP, the S&P 500 Index delivered a total return of 126% over the next five years (i.e., from 2008 to 2013).

On the other hand, in late 1999, the Buffett Indicator reached a level that was nearly as high as today’s extreme reading. Over the next five years, the S&P 500 produced a loss of 11%.

Clearly, the starting price matters when making an investment. That’s why buying U.S. stocks at their current lofty valuations could be a risky bet.

But the lessons of history are not all doom and gloom. For long-term investors, history provides a much more hopeful and optimistic lesson: Time covers a multitude of investment sins, like the “sin” of buying richly valued stocks just before a major market top.

For example, even if you had purchased a stock like Wal-Mart or McDonald’s exactly one day before the crash of 1987, your investment would have soared more than 400% over the ensuing 10 years.

Or if you had purchased Amazon or Apple at the very peak of the dot-com mania of 2000, you still would have fared quite nicely over the next 10 years. Despite suffering immediate and enormous mark-to-market losses of more than 80% on both stocks, your investment in Amazon would have doubled over the next 10 years, while your investment in Apple would have soared more than 800%!

If you still held those positions today, you’d be sitting on a 1,500% gain on your Amazon stock and a gain of more than 3,700% on your Apple stock. And remember, those are the results you would have achieved from investing at these stocks at the very top of the dot-com mania.

Investing in winning companies is much more important than investing at the lowest levels of a bear market. That said, investors should not be careless about the prices they pay for stocks. Buying low is certainly better than buying high.

So one very easy way to avoid “top ticking” is to dollar cost average your investments – that is, to invest over time. Instead of buying your position in a stock all at once, you would buy a fixed dollar amount of that stock every month until you had completed your intended investment.

That sort of discipline can be very helpful because it removes emotion from the equation.

No matter your personal risk tolerance, and no matter your investment time frame, corrections are never easy to endure. So be sure to establish a realistic investment program that anticipates short-term setbacks along the way to long-term success.

Good investing,

Eric