We came across an article recently that does a really nice job of answering one of the most common questions we hear from our clients, and that is: With markets setting new highs, should we be expecting a downturn?
The answer is both yes, and no. Yes, because markets tend to fluctuate, so over the course of your investment lifetime, you should definitely expect some ups and downs. And no; the fact that markets are setting new highs does not give us any information about what is about to happen next.
Let’s unpack this idea, and as always, back it up with some evidence. First off, why do investors tend to expect a downturn following a new-high in the markets? There are a lot of explanations, but central among them, is the media’s propensity for promoting articles that entice fear. Humans are hard-wired to avoid risk, so the media has an incentive to write headlines that grab our attention by playing on our fear motives. The result? On any day of the week, you will find an article in the financial press, written by seemingly credible individuals, claiming that the end is near. What do they have to lose after all? If they are right, they will be heralded an oracle, and if they are wrong, no one will remember anyway. So, fear-based articles are good business for the media – they get a lot of attention and help drive advertising revenue. Individual investors, however, are all too often the casualties of such headlines.
On to some evidence. If we were to ask you: what is the likelihood that the S&P 500 stock market index will be higher than it is today, twelve months from now, what would you say? Of course, no one knows for sure, but we can learn from history. It turns out that if we examine all 12 month time periods between 1926 and the end of 2017, 75% of those time periods yielded positive investment returns. Further, if instead of 12 month time periods, we were focused on three or five year increments, the odds were better still. It turns out that 83.5% of all three year periods yielded positive returns to investors, and 87.5% of all five-year periods were positive.
Overwhelmingly, markets tend to go up in value over time, but we still need to understand if markets making a new high today signals a pending downturn. In other words, is this the peak, or just a step in the staircase? Examining the returns of the S&P 500 over the same arc of time (1926-2017), what if we again looked at one, three and five year time increments, but this time only examined the periods immediately following a new stock market high? It turns out that the frequency of positive returns actually improves to 80.9%, 84.2% and 84.2% respectively for one, three and five year time periods. This result is counter-intuitive to many investors who errantly assume that what goes up, must come down.
Back to the “yes and no” answer, to the “should we expect a downturn?” question from earlier. The “yes” part of the answer is what keeps investors up at night. What the evidence shows, however, is that approximately 80% of the time the answer to that question has been “No”, while just 20% of time the answer was “Yes”. That is to say, if you were to have sold your investments each time the market set a new high, 80% of the time you would have been worse off for doing so. Further, new-market highs happen very frequently – in fact, the financial markets hit a new high every three months, on average. This is despite the fact that we have never reached an investing nirvana: a world where there is nothing to worry about, and it is absolutely clear that markets will continue to advance. But, we need to be careful what we wish for because if markets had no risk of going down, then the commensurate expected return would be comparable to a GIC, treasury-bill, or a Canada Savings bond. There will always be some headline that lends itself well to an “end of the world” media narrative, be it the US President’s Twitter account, trade wars, or tariffs. Unfortunately, none of these events give us a clear signal that market returns are about to falter, so absent a crystal ball, we are best to ignore the noise in the media, and remain invested for the long-term.