Interactive Investor

Why investors should stay the course even when markets are red-hot

14th May 2021 10:31

Faith Glasgow from interactive investor

Loading

Share on

Faith Glasgow reports on analysis that demonstrates how attempting to call the top of the market is likely to be a mug’s game over the long term. 

Many investors have heard many times that for long-term investment success it is time in the market, not timing the market, that counts.

But as recent analysis from Schroders makes clear, various popular valuation measures point to the US market now being exceptionally expensive. So should alarm bells be ringing, especially considering US predominance in global funds as well as focused US ones?

Duncan Lamont, author of the Schroders report, notes at the end of March the S&P 500 Index was valued at 34 times its earnings over the previous 12 months. That’s above the peak of the dotcom boom in 1999, when it reached 31 times, and double the 50-year average.

Even when earnings are smoothed over a longer timescale to take account of any distortions as a result of the pandemic’s impact, the market is red-hot.

The cyclically adjusted price-earnings multiple, known as CAPE, compares share prices over average earnings for the past 10 years; it shows the US market trading on a CAPE of 36 times at the end of March. That’s more than twice the long-term CAPE average of 17. “The only time in history it has been higher was at the apex of the dotcom boom,” Lamont observes.

While this might suggest it is in for a serious tumble, he argues that the old adage about time in the market still holds good. The cost to investors of selling out because it is toppy is likely to be higher, over the long term, than that of staying put and taking a short-term hit.

Lamont illustrates this with the example of a strategy based on selling out of the US stock market when its CAPE valuation moves to more than 50% above the long-term average of 17 times (the ‘50% overpriced’ point), and buying back in when it falls below that level.

Looking back over 130 years, that has occurred 14 times (although some lasted just a month or two).

“If you made these decisions based on the CAPE multiple, youd have been out of the stock market since 2013, bar a few scattered months. Youd also have sat out not just the later stages of the dotcom bubble, but also the earlier years. And most of the years in the run-up the financial crisis,” says Lamont.

But while you would have missed the stress and anxiety of those roller-coaster periods, you’d also have missed out on 43% of the potential gains available as the market continued to rise before it peaked.

Moreover, if you dispensed with timing altogether and stayed invested throughout the entire fall each time, the Schroders research suggests you would still be better off overall than if you’d followed the ‘50% overpriced’ exit strategy.

In 10 out of the 14 ‘50% overpriced’ periods for the CAPE multiple, the US market delivered a positive return because the losses incurred were smaller than the preceding gains. On five of those occasions net gains were double-digit. On the four net loss occasions, the losses amounted to 5% or less.

Lamont calculates that overall, the average annual return for someone who remained invested throughout the past 130 years amounted to 9.7%; a fellow investor who followed the ‘50% overpriced’ exit strategy would have enjoyed a return of 7.4%.

In the context of the very long term, such seemingly small variations can make a massive difference, says Lamont: “$100 in the switching strategy in 1890 would now be worth $1.1 million. Pretty good. But $100 in the one which stayed invested would now be worth $18.1 million.”

None of us are looking at anything like such a time frame, of course, but the point remains valid: better permanently in than selectively out.

What about the current bull run? In a nutshell, it will eventually come to an end, but the US market is likely to get more expensive before then.

As Ben Yearsley, investment director at Shore Financial Planning, observes, there’s also the likelihood this year that valuations will get cheaper without share prices falling. “Growth this year is going to be extraordinary,” he says. “This should result in excess earnings for companies, in turn bringing the pice to earnings ratio down.”

Yearsley sees the increasingly technology-focused world as further underpinning market strength. “The US has been a tech leader for many years and will continue that dominance; tech is not retreating from everyday life, so thats one reason to stay invested,” he argues. 

Whatever happens, attempting to call the top of the market is likely to be a mug’s game over the long term.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Get more news and expert articles direct to your inbox

Sign up for a free research account to get the latest news and discussion, and create your own virtual portfolio.

Free Sign Up