New Market Highs and Positive Expected Returns
With permission from Dimensional Fund Advisors LP.
There has been much discussion in the news recently about new nominal highs in stock indices like the Dow Jones Industrial Average and the S&P 500.
When markets hit new highs, is that an indication that it’s time for investors to cash out? History tells us that a market index being at an all-time high generally does not provide actionable information for investors. For evidence, we can look at the S&P 500 Index for the better part of the last century. Exhibit 1 shows that from 1926 through the end of 2016, the proportion of annual returns that have been positive after a new monthly high is similar to the proportion of annual returns that have been positive after any index level. In fact, over this time period almost a third of the monthly observations were new closing highs for the index. Looking at this data, it is clear that new index highs have historically not been useful predictors of future returns.
Given that the level of an index by itself does not seemingly have a bearing on future returns, you may ask yourself a more fundamental question: What drives expected returns for stocks?
Exhibit 1. S&P Total Return Index Highs: 1926–2016
Percent of Months With Positive Return Over Next 12-Month Period
From January 1926–December 2016, 319 months, or approximately 29% of monthly observations, were new closing highs. Note: 1,081 monthly observations. The S&P data is provided by Standard & Poor’s Index Services Group. For illustrative purposes only. Index is not available for direct investment. Past performance is no guarantee of future results.
POSITIVE EXPECTED RETURNS
One way to compute the current value of an investment is to estimate the future cash flows the investment is expected to deliver and discount them back into today’s dollars. For an investment in a firm’s stock, this type of valuation method allows expectations about a firm’s future profits to be linked to its current stock price through a discount rate. The discount rate equals an investor’s expected return. A simple, but important, insight we glean from this is that the expected return from holding a stock is driven by the price paid for it and what its investors expect to receive.
For more information, please contact your Dopkins Wealth Advisor or call 716-634-8800.