14 July 2016

Why All-Time Market Highs Are Largely Meaningless

The S&P 500 is at an all-time high. Optimists point to this as proof that things are great, have never been better. Pessimists point to it as further proof that market prices are irrationally inflated, a bubble ready to burst. An all-time high doesn't signal either outcome.

If you put $10,000 into an account that paid a 0.5% annual rate, compounded daily, your account would hit a "new high!" every day. Every day.

Compound interest rates mean continuously higher value. The reason the market does not hit a new, all-time high every day is simply because the market is really volatile. It can hit a high one day that it takes years to again reach. But over the long-run, it is like that savings account in that it - with fits and spurts and leads and lags that can distort the effect of steady returns - will hit a new high with some regularity.

Is the market a bubble ready to burst?
One argument against that is here in this data on the S&P 500:
From 1950 to 2000, the annual return was 9.4%
Since 2000, the annual return has been 0.8%.
This alone could suggest that the market could rise quite a lot without reaching excessive levels over the long-run.

Is the market under-priced and ready for a huge rally?
One argument against that is here in this data on Price to Earnings (PE) Ratio.
From 1950 to 2000, PE ratio for the S&P 500 averaged 15.3
Since 2000, it has averaged 25.5
This alone would suggest that the market is not under-priced.

So what will the market do?

I think the stock market will be driven by bond prices. Within the last week, the interest rates on Dutch bonds went negative for the first time in 499 years. About a day later, German bonds went negative. Investors are actually paying governments to take money. That suggests two things. One, people are really risk adverse, actually embracing a small loss rather than risking a big one. Two, anyone interested in returns will be forced into investments other than bonds and the most obvious of those is stocks. As people finally remember that uncertainty is not a new thing but is instead what characterizes markets, they'll accept more risk and will likely take on that risk by buying stocks. Given that returns on bonds are so low, people will accept lower returns on stocks, which means that the PE will go up. As the global economy continues to grow, that means that earnings will also go up. So, the combination of rising PE and rising earnings should mean a really strong stock market through the rest of this decade.

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