Stocks Are Near Record Highs: Should We be Worried?
U.S. stocks have almost doubled in value since the Pandemic sell-off in mid-March of 2020. Since that time, the S&P 500 Index has set 74 all-time closing highs, the most recent occurring on September 2nd. While this has been an incredible bull market run, for some investors, markets hitting record high levels produces fear that a big correction is just around the corner. Is this fear justified? Record highs, in and of themselves, can’t be a bad thing, can they?
Before we look at the data, let’s take a moment to think a little deeper about this. What would it mean if our stock market stopped hitting new highs? On a personal level, it would mean that the value of your stock portfolio would stagnate, though you might keep receiving dividend payments for a while.
On a macro level, a persistent sideways or declining stock market would imply that publicly owned companies can no longer grow their earnings, revenue, and cash flow. This would put pressure on dividend paying companies as the costs of doing business increased over time without the benefit of increasing cash flows.
This, in turn, is indicative of a stalled economy which has stopped growing altogether. This is because there is a close connection between the level of real economic activity (production of goods and services) and the value of the financial ownership claims on the real assets in the economy. If the economy shrinks over time (a recession), we would expect a declining stock market as corporate profits and revenues fall in sync with the economy, not to mention rising unemployment and declining consumer spending.
Recent research from Dimensional Fund Advisors (DFA) sheds some empirical light on this topic. Over the 94-year period ending in 2020, using month-end data, the S&P 500 Index produced a new high in 231 out of the total of 768 months, or about 30% of the time. This should not come as a surprise to us. The growth in the U.S. economy since 1926 must, as we said, correspond with the wealth creation accruing to owners of growing publicly traded companies. If it were not so, why would anyone ever put capital at risk in the stock market?
The DFA research also addresses the fear-factor of what happens after markets set new record highs. The following table shows the average annualized returns for the S&P 500 Index after one-, three-, and five-year periods for the same 94-year period after a new market high. (Notice, too, the surprising fact that the historical average annualized returns are actually slightly lower if you purchased shares after a 20% decline versus after a new high.)
We like how DFA summarized their research, especially speaking to those investors who think they can successfully predict and time market corrections:
“Humans are conditioned to think that after the rise must come the fall, tempting us to fiddle with our portfolios. But the data suggest such signals only exist in our imagination and that our efforts to improve results will just as likely penalize them. Investors should take comfort knowing that share prices are not fighting the forces of gravity when they move higher and have confidence that record highs only tell us the system is working just as we would expect—nothing more.
I know of no research firm or economist who is currently projecting negative U.S. stock market returns over the next five to ten years. They could all be wrong, of course, but our guess is that we will continue to see the market hit new record highs over the next ten years. This is based on our hope that the U.S. will continue to be one of the best places on Earth for entrepreneurs and business owners, provided, of course, that the economic and political environment for capitalism, free enterprise, and the rule of law remains favorable.
John Finley, CFA, serves as Chief Investment Officer for Coyle Financial Counsel and is responsible for overseeing the investment process. John’s prior experience includes managing institutional fixed-income portfolios for corporations, pension funds, non-profit organizations and foundations at several large, global asset managers. With more than 20 years of institutional investment experience, he is energized by helping individuals understand the role investing plays in meeting their long-term financial goals.
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 Hartford Funds: By The Numbers 08.30.21 and finance.yahoo.com
 An index like the S&P 500 Index is not directly investable and the returns shown do not include any fees or expenses.
 Fortunately, there are significantly fewer 20% declines than new record highs.