Is the Market Overheated?

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The S&P 500 is up over 15% YTD through yesterday. Chances are, if you have ever read anything about investing, you have heard that the stock market averages 10%[i] over the long term. Increasingly, as we’ve trudged upwards this year, I’m being asked if the market is overheated.

With the already announced reduction of the Fed’s money printing program this month along with the increasing speculation that they will probably raise rates in December, it does look like some of the easy money tailwinds we've seen for nearly a decade may finally be subsiding. Mix in a history of some pretty awful past Octobers (1929, 1987, 2008), and it isn’t the craziest notion to have concerns about the market running about 50% hotter than its long-term average.

Care to venture a guess how many times the S&P 500 has had a yearly return 15% or more over the last 90 years or so?[ii]

A)      Once

B)      Ten

C)      Twenty

D)      Forty

The correct answer is D. In fact, in only six years over that span has the market even finished within two percentage points of 10%.

Exhibit 1[iii] shows calendar year returns for the S&P 500 Index since 1926. The shaded band marks the historical average of 10%, plus or minus 2 percentage points. The S&P 500 had a return within this range in only six of the past 91 calendar years. In most years the index’s return was outside of the range, often above or below by a wide margin, with no obvious pattern. For investors, this data highlights the importance of looking beyond average returns and being aware of the range of potential outcomes.


Exhibit 1.       S&P 500 Index Annual Returns 1926–2016

In US dollars. The S&P data are provided by Standard & Poor's Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Index returns do not reflect the cost associated with an actual investment.

In US dollars. The S&P data are provided by Standard & Poor's Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Index returns do not reflect the cost associated with an actual investment.

 

So, am I concerned? Considering I typically don’t make charge fees in months that the market drops, I’d say…yes. Always.

But I also believe in the power of markets, and that all available information is incorporated into the current price of every stock. The market reflects all that information, and we assume no investor willingly has risked capital they expect to lose.

I haven’t been around for all of 40 of the years we’ve seen 15%+ returns over the past 90 years or so, but I’ve fielded similar questions every time stocks have had a better than average run during the quarter century that I’ve been doing this. Admittedly, it’s easier to convince clients to stay the course in good years, but when our belief in markets is tested during the next correction (10% downturn) or bear market (20% decline), I will offer a similar response.

Despite our inability to consistently predict what the markets will do in advance, we are all well served to remember that keeping a long-term perspective gives us the best chance of having a positive outcome with our equity investments. Exhibit 2[iv] shows the historical frequency of positive returns over rolling periods of one, five, 10, and 15 years in the US market. The data shows that, while positive performance is never assured, investors’ odds improve over longer time horizons.


Exhibit 2.       Frequency of Positive Returns in the S&P 500 Index
Overlapping Periods: 1926–2016

From January 1926–December 2016 there are 913 overlapping 15-year periods, 973 overlapping 10-year periods, 1,033 overlapping 5-year periods, and 1,081 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. In US dollars. The S&P data are provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not an indication of future results.

From January 1926–December 2016 there are 913 overlapping 15-year periods, 973 overlapping 10-year periods, 1,033 overlapping 5-year periods, and 1,081 overlapping 1-year periods. The first period starts in January 1926, the second period starts in February 1926, the third in March 1926, and so on. In US dollars. The S&P data are provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not an indication of future results.

There aren’t any free lunches when it comes to investing. To earn returns that exceed the risk free rate of cash or short term government bonds, we must take some risk. Managing that risk (and our emotions) during the ups and the downs can be easier when we have an understanding of how markets work and have behaved in the past. If you are having trouble sleeping at night because of your portfolio, you probably should work to align your asset allocation with the amount of risk you can tolerate. Get in touch if you could use some help.

 

 

 

[i] As measured by the S&P 500 Index from 1926–2016.

[ii] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

[iii][iv] Source: Dimensional Fund Advisors LP.

 

There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. Diversification does not eliminate the risk of market loss.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.