The Market Hits All-Time High. So What?

By Dianne F. Lob and Ding Liu, AllianceBernstein

With the US stock market repeatedly reaching all-time highs in recent weeks, many investors are becoming leery of investing in stocks. Focusing on the market’s level is a mistake, in our view. It’s market valuation, not level, that matters.

Since 1900, the S&P 500  Index has been close to (within 5%) of its prior peak almost half the time. There’s a simple reason for this. The stock market goes up over time, along with the economy and corporate earnings. As a result, the market typically has regained its prior peak level fairly quickly after dropping. Then, it has resumed its upward march (Display 1).

Lob-Prior-Peak_display1_d51

 

Fear of investing at market peaks is understandable. In the short term, there’s always the risk that other investors will decide to take gains, or that geopolitical, economic or company-specific news will trigger a market pullback.

But for longer-term investors, market level has no predictive power. Market valuation—not market level—is what historically has mattered to future returns  (Display 2).

Lob-Prior-Peak_display2_d5

 

The green bars on the left side of Display 2 show average market returns after points at which the market level was close to its prior peak. The dotted line shows average market returns after all points since 1970 (we don’t have good valuation data before then).  Over 1-, 3-, 5- or 10-year periods, annualized returns were about the same after points at which the market was close to its prior peak level as after all points since 1970.

Display 2 also shows that buying when the market was at least 5% below its prior peak level (indicated by the blue bars) didn’t help much. It added slightly to annualized returns over 1- and 10-year periods, but detracted from returns over 3- and 5-year time periods.

By contrast, buying at high valuations detracted significantly from returns—and buying at low valuations added significantly. The green bars on the right side of Display 2 show annualized average market returns for 1-, 3-, 5- or 10-year periods after market valuations were expensive, based on price-to-trailing earnings; they’re far below the dotted line that indicates showing the average for each period since 1970. The blue bars show returns after points when market valuations were low; the returns for these periods were significantly above average.

What does all this mean for investors today? The S&P 500 may be at an all-time high level, but it’s far below its all-time high valuation. At 18.7 times trailing earnings, the US market today is more expensive than average but it’s not extremely expensive (Display 3). Outside the US, however, equities haven’t rebounded as far, so the MSCI World Index  of developed-market equities remains close to its long-term average valuation.

Lob_PriorPeak_display3_d8

 

But with interest rates still near historical lows, bonds are extremely expensive. Both US and global stocks are very attractively valued versus bonds, as shown by the earnings yield premium bars on the right side of Display 3.

While there’s always the risk of a market correction, we think long-term investors should invest in stocks at close to their strategic allocations. And, as always, it’s wise to diversify globally.

The views expressed herein do not constitute research, investment advice, or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein.

Dianne F. Lob is Chairman, Private Client Investment Policy Group at Bernstein Global Wealth Management, a unit of AllianceBernstein. Ding Liu is a Senior Quantitative Analyst at Alliance Bernstein.

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Comments

  1. I can agree with the article on valuation vs. the level of the market. But the article on its own is missing so many things that it should not be used to conclude anything about asset allocation.

    From the article:

    “The S&P 500 may be at an all-time high level, but it’s far below its all-time high valuation. At 18.7 times trailing earnings, the US market today is more expensive than average but it’s not extremely expensive”

    Looking at P/E ratios alone does not make any sense. In 2006-2007 allot of peolpe wrote that stocks looked cheap on P/E-ratios, the problem is they did not consider if a collapse in the financial sector could happen and if it could have a negative effect on the global economy and asset prices. Systemic risk was left out of the equation, just like today.

    I am also a little sceptical about the “E” in the P/E-ratio. I wonder if most of the “E” is generated by the financial sector. If so do they use any accounting rules that have changed over time? Some peolpe have wriiten over the years that banks are showing higher profits because of a change in accounting rules, if that is true would earnings in the financial sector have been much higher in for instance 1999 if they used the same accounting rules back then? Would that lower the P/E-ratio in 1999 so todays P/E-ratio is much closer to the P/E-ratio in 1999? I am no expert that is why I am asking these questions.

    Also from the article:

    “But with interest rates still near historical lows, bonds are extremely expensive. Both US and global stocks are very attractively valued versus bonds, as shown by the earnings yield premium bars on the right side”

    First of all you should not invest in one asset because it looks attractive compared to another asset. If you invest in stocks you do it because you expect to be compensated for risk, inflation and taxes over a longer period of time. You should look at stocks alone, you can take bonds into consideration by asking, if bonds are mispriced will they mean revert and will it have any effect on stock prices?

    The second problem is when you compare earnings yield with bond yield. You completely forget risk wich does not make any sense at all. Also what is the difference between a portfolio of bonds with a Beta of 1 and a portfolio of stocks with a Beta of 1 (other than taxes)? Bonds can also offer a good return and different risks.

    I do not know how exactly to incorporate systemic risks into the valuation equation but is not a reason for leaving them out. As some clever economists once wrote “economics is more art than science” so maybee it is not that bad to be a little subjective looking at systemic risks.

    In my opinion the “All-in Abenomics experiment” is the next big thing, lets hope they succed, I do not think they will….time will tell.

    LuisFugo

  2. This is typical marketing gibberish. Another excuse to make sure that the retail investors keep paying those equity mutual fund fees.

    If valuation matters, than why a PE of 18 should mean that stocks can get more expensive from here? The answers is: valuation does not always matter. The market does its own thing.

  3. If a new high is not important, then why so may take the time to say that it is not important…

  4. This, of course, is easier said than done. Even the most disciplined investors exited the markets in the 1930s, never to return…If you want to earn high returns, be prepared to suffer grievous losses from time to time. And if you want perfect safety, resign yourself to low returns…High investment returns cannot be earned without taking substantial risk. Safe investments produce low returns.