Given recent headlines about indices like the Dow Jones Industrial Average and the S&P 500 Index hitting all-time highs, I thought I would share a piece I received this month from Dimensional Fund Advisors (Dimensional). Dimensional poses this essential question: When markets hit new highs, is that an indication that it’s time for investors to cash out?
Dimensional’s historical evidence suggests that a market index being at an all-time high should not signal it’s time to sell. For example, returns for the S&P 500 from 1926 through the end of 2016 show the proportion of positive annual returns after a new monthly high is similar to positive returns following any index level. In fact, almost a third of the monthly observations were new closing highs for the index. So, new index highs have historically not been a useful sell signal.
Figure 1: S&P 500 Total Return Index Highs: 1926–2016
Percent of Months with Positive Return Over Next 12-Month Period
Rather than using past performance to predict future performance, Dimensional stresses that it is more useful for investors to understand what drives stock returns. Here’s their helpful explanation: “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.”
This way, fundamentals, not emotions drive your investment decisions.
What is Dimensional’s bottom line to this analysis? “While positive realized returns are never guaranteed, equity investments have positive expected returns regardless of index levels or prior short-term market returns.”
And, given that history shows us that over longer time horizons the odds of realized stock returns being positive increase, it is wise to maintain a long-term investment view.