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Why record stock market highs are exactly the outcome you should expect

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In recent months it’s been common – particularly when it comes to the US – to see news headlines about “record stock market highs”.

When you read these, what do you think? Are you encouraged by the market’s progress, or do you see a bubble that’s set to burst?

This excellent article from Weston Wellington, vice-president of Dimensional Fund Advisers (whose funds we use in our model portfolios), explains why record stock market highs are exactly what you should expect.

Key takeaways

  • Financial journalists periodically stoke investors’ record-high anxiety by suggesting the laws of physics apply to financial markets—that what goes up must come down.
  • But shares are not heavy objects kept aloft through strenuous effort. They are perpetual claim tickets on companies’ earnings and dividends.
  • If stocks have a positive expected return, reaching record highs with some frequency is exactly the outcome we would expect.

Investors are often conflicted about record-high stock prices. They are pleased to see their existing equity holdings gain in value but apprehensive that higher prices somehow foreshadow a dramatic downturn in the future.

And they may be reluctant to make new purchases since the traditional “buy low, sell high” mantra suggests committing funds to stocks at an all-time high is a sure-fire recipe for disappointment.

Financial journalists periodically stoke investors’ record-high anxiety by suggesting the laws of physics apply to financial markets – that what goes up must come down. ‘Stocks Head Back to Earth,’ read a headline in the Wall Street Journal in 2012.[1]

‘Weird Science: Wall Street Repeals Law of Gravity,’ Barron’s put it in 2017.[2] And a Los Angeles Times reporter had a similar take last year, noting that low interest rates have “helped stock and bond markets defy gravity”.[3]

Those who find such observations alarming will likely shy away from purchasing stocks at record highs. But shares are not heavy objects kept aloft through strenuous effort. They are perpetual claim tickets on companies’ earnings and dividends.

Thousands of business managers go to work every day seeking projects that appear to offer profitable returns on capital while providing goods and services people desire. Although some new ideas and the firms behind them end in failure, history offers abundant evidence that investors around the world can be rewarded for the capital they provide.

Whether at a new high or a new low, today’s share price reflects investors’ collective judgement of what tomorrow’s earnings and dividends are likely to be – and those of all the tomorrows to come.

And every day, stocks must be priced to deliver a positive expected return for the buyer. Otherwise, no trade would take place. It’s difficult to imagine a scenario where investors freely invest in stocks with the expectation of losing money.

Investors should treat record-high prices with neither excitement nor alarm, but rather indifference. If stocks have a positive expected return, reaching record highs with some frequency is exactly the outcome we would expect.

Using month-end data over the 94-year period ending in 2020, the S&P 500 Index produced a new high in ending wealth in more than 30% of those monthly observations.

Moreover, purchasing shares at all-time records has, on average, generated similar returns over subsequent one-, three-, and five-year periods to those of a strategy that purchases stocks following a sharp decline.

The table below shows the average annualised returns for the S&P 500 Index after market highs and declines.

For illustrative purposes only. Index is not available for direct investment. Performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

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 penalise 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.

Get in touch

If you have any questions about the markets or your investments, please get in touch. Email hello@sovereign-ifa.co.uk or call us on 01454 416 653.

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision.

It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited.

Dimensional accepts no responsibility for loss arising from the use of the information contained herein.

Issued by Dimensional Fund Advisors Ltd. (DFAL), 20 Triton Street, Regent’s Place, London, NW1 3BF. DFAL is authorised and regulated by the Financial Conduct Authority (FCA). Information and opinions presented in this material have been obtained or derived from sources believed by DFAL to be reliable, and DFAL has reasonable grounds to believe that all factual information herein is true as at the date of this document.

DFAL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DFAL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

[1] Jonathan Cheng and Christian Berthelsen, ‘Stocks Head Back to Earth’, Wall Street Journal, 11 February 2012.

[2] Kopin Tan, ‘Weird Science: Wall Street Repeals Law of Gravity’, Barron’s, 7 August 2017.

[3] Russ Mitchell, ‘Tesla’s Insane Stock Price Makes Sense in a Market Gone Mad’, Los Angeles Times, 22 July 2020.

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