“The market looks too expensive at the moment. I think it’s due a correction, so I’m just going to wait for a bit of a dip before I get invested.”
It sounds like a sensible strategy. “What goes up must come down” feels relevant, and the power of mean reversion seems like it should bring the market back down to earth with a bang at any moment.
But is that actually the case?
There are a couple of metrics which people tend to use to justify saying that the market looks “expensive”. The first is when the market reaches new all time highs, and the second is when the cyclically adjusted price-earnings ratio (CAPE, for short) is above its long-term average.
[NB: The CAPE ratio is a valuation measure based on the usual price-earnings ratio, but uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.]
Let’s take each of these metrics in turn.
Should you invest if the market is at all time highs?
Investing at all time highs can be scary, because it feels like investing at the highest point the market has ever been at means there must be a crash coming.
We remember past market peaks, and the crashes that followed. Everyone’s seen the charts that show steadily rising markets, then a peak, then a crash. These charts stick in our heads, and make us fearful that this might just be peak before the crash.
The problem that people face when thinking about all time highs is that every market crash in history was preceded by an all time high. It’s a mathematical fact that every crash, every drawdown, every correction, must have come after an all time high. We don’t quantify the magnitude of a crash from any other point – it’s always measured from the lowest point in the crash to peak that came before it. So when you hear that “the market crashed 40%”, it’s always a 40% drop from the previous peak. We trace back the crash to the previous high, and that becomes the figure we use to quantify the market’s losses.
It then becomes easy to associate all time highs with large drawdowns.
But this sort of thinking arises from faulty reasoning. It’s the classic “all elephants are grey, but not all grey things are elephants” logic. All market crashes have been preceded by an all time high, but not all all time highs are followed by market crashes.
In fact, it’s quite the opposite. Statistically speaking, market highs usually lead to more market highs.
For example, Ben Carlson of Ritholtz Wealth Management looked at over 100 years of data on the Dow Jones Industrial Average going back to 1915. He found that since that time, stocks had 1,252 highs, which works out to an average of about 12 new highs every year, or roughly once a month:
Source: Ben Carlson
Looking at it visually, you can see how often the market reaches all time highs and doesn’t crash. The red dots on the chart below denote a new all time high:
Source: Ken French data library
The chart shows:
- How often the market makes new all time highs and doesn’t crash. After the Great Depression in 1929, new highs are perfectly ordinary and occur relatively often. It would have felt scary to invest at any of those red points, but most of the time, all time highs are followed by more all time highs.
- How bad the Great Depression actually was for markets. The dotcom crash in 2000 and the GFC in 2008 look tiny in comparison to the 1929 crash – in 1929 the market fell 84% and took 16 years to recover.
So it looks like market highs are nothing to worry about and seem perfectly normal.
But what about the expected return after reaching an all time high? Is the small risk of a big drawdown large enough to offset the high chance that markets keep rising?
The table below, again from Ben, shows how the Dow has performed one, three and five years after reaching a new high:
Source: Ben Carlson
Even when the market reaches all time highs, there’s still a 70% chance of a positive expected return over 1, 3, and 5 years, with an average return of between 6% and 9%.
All time highs are nothing to worry about.
Should you invest if the market has a high valuation versus its history?
The other way people judge whether a market is expensive is by looking at its “valuation”, usually measured using it cyclically adjusted price-earnings ratio (CAPE ratio).
The idea behind waiting to invest is that CAPE tends to be mean reverting. The market will start taking advantage of any divergences between a company’s share price and its underlying earnings, brining CAPE back to its average level. If a company’s price falls too much versus its earnings, the market will realise it’s undervalued and buy more shares, which raises the price – and vice versa.
So with that in mind, does it make sense to delay investing if the CAPE is trading at above average levels?
Researchers at Elm Funds crunched the numbers. They looked at what the average cost or benefit was of waiting for a 10% correction from the starting price level during times when the market was “expensive”, versus investing right away. They focus on a comparison over a 3-year horizon, which chosen because most investors are unlikely to wait indefinitely for a hoped-for correction.
[NB: They define “expensive” as times when the stock market had a CAPE (Cyclically-adjusted Price-Earnings Ratio) that was more than one standard deviation above its historical average level.]
The most interesting findings were:
- From a given “expensive” starting point, there was a 56% probability that the market had a 10% correction within 3 years, waiting for which would result in about a 10% return benefit versus having invested right away. (The cost or benefit is calculated as the return difference over the full 3 years between being fully invested for the entire period versus waiting for the 10% correction and re-entering the market when and if it occurs. Carry from dividends and cash yield are both included in the differential return calculation.)
- In the 44% of cases where the correction doesn’t happen, there’s an average opportunity cost of about 30% – much higher than the average benefit.
- Putting these together, the mean expected cost of waiting for a correction was about 8% versus investing right away.
Whilst the probability of a 10% correction within 3 years was over 50%, the 10% return benefit of waiting for a correction was outweighed by the less-likely but much-larger cost of waiting to invest while the market rose (a cost of 30%).
Your expected return would’ve been 8% higher if you’d invested right away, rather than choosing to wait for a correction.
But the research doesn’t stop there. A 10% drawdown target over 3 years is just possible scenario, so Elm looked at what the expected benefit/cost of waiting was using different drawdown targets (1% to 10% drawdowns), over different time horizons (1 year, 3 year, 5 years), and using different definitions of what “expensive” means. Each point of the chart below represents a combination of those assumptions:
Source: Elm Funds
The chart has a couple of interesting findings:
- Across all scenarios, there was a cost to waiting (all dots have a cost >0%). So investing right away would have had higher returns in all scenarios.
- This cost increased the longer you waited (the red dots have a higher cost than the green, which have a higher cost than the blue).
One of the factors that makes waiting for correction in an expensive market so difficult, is that markets can remain expensive for a really long time.
In the past 20 years, the S&P 500 has had a CAPE Ratio above its historical average 97% of the time or in 233 out of 240 months, according to research from Charlie Bilello of Pension Partners. Only in the brief period from November 2008 through May 2009 were stocks deemed “undervalued,” trading at valuations below their long-term average.
Long periods above or below the historical average valuation are not as uncommon as one might think. A market that is undervalued can remain undervalued for a long time, just as a market that is overvalued can remain overvalued for what seems like an eternity.
The table below shows the “streaks” of how long the S&P remained above or below its average valuation since 1900:
Source: Pension Partners
If you’d waited to invest because you thought markets were overvalued in 1988, you would have been waiting almost 20 years (until 2008) before actually investing. Meanwhile, the market would have gone up over 420%.
There’s nothing that says an overvalued market cannot go higher. In fact, more often than not, it does just that. The table below shows that even when the market’s in the most expensive decile (the 90th – 100th percentile), the forward returns are still positive – even regardless of time period:
Source: Pension Partners
And it’s not unheard of for stocks to reach the most extreme of CAPE levels, and carry on rising. The chart below shows how much stocks in Japan gained at different CAPE levels in the 1980s. During the 33 month period it took for the CAPE to go from 80 to 94.3, the Japanese stock market rose 67%.
Source: Michael Batnick
So markets can remain expensive for a very long time. But the chances are that you can expect positive returns from a market that looks expensive, even when it reaches levels which look extreme.
Market valuations versus future returns
Whilst it’s likely that expensive markets continue to be expensive, markets trading at higher valuations do have lower expected returns than cheaper markets.
You can see that clearly from the S&P 500 forward returns vs valuation percentile table in the section above. Forward returns tend to be higher when valuations are lower, and forward returns tend to be lower when valuations are higher.
I’ll be writing a later post on whether valuations can be used to increase performance by rotating between cheap/expensive regions, but for now the point is that expensive markets mean lower returns are likely.
Looking at it from a risk perspective rather than a return perspective, research from Star Capital shows that higher valuations mean that when a crash comes, it’ll likely be larger than if the market had been cheap. When stocks have been in the most expensive quintile of historical valuations, the average drawdown when that cycle ends is a loss of 37%. When stocks are in the cheapest quintile of historical valuations, the average drawdown is just 5%:
Source: Star Capital
So the downside risk of stock markets increases with rising valuation levels. Expensive stock markets increase the risk of a larger drawdown.
Whilst expensive markets still have positive expected returns, the returns are lower than they’d be if the market was cheaper, and do come with higher risk.
- All time highs are scary, but happen roughly once a month.
- They’re far more often followed by more all time highs than they are followed by crashes.
- Investing at all time highs still has a positive expected return.
- When looking at CAPE ratios, waiting for a correction produces lower returns, and the returns worsen the longer you wait.
- Markets can remain expensive for a very long time, so delaying investing means missing out on potentially long periods of returns
- Higher market valuations imply lower expected returns (but not negative).
- Higher market valuations also increase the risk of a larger drawdown.
The next post in the series looks at what would happen if you were the world’s worst investor, and invested right before a market crash.