“‘Melt Up’ Rally Propels Dow Above 26,000 as Fear Turns to Greed” proclaimed The Wall Street Journal this morning. The headline comes as optimism in our weekly sentiment survey is staying at an unusually high level. Even outside of the office, more people have been bringing up the market’s run to me in conversations.
The current market environment does not feel like the dotcom bubble (some of you have expressed concerns about the market's valuation and/or the possibility of a forthcoming drop in stock prices), though there are similarities. We’re in the midst of an extended bull market. Tech and internet company stocks have done well. There’s a bubble in emerging technology companies, especially those associated with cryptocurrencies. (At least during the dotcom bubble, you could buy gifts from Toys.com and dog food from Pets.com. Good luck buying either from a national retailer with bitcoin, ether or ripple.)
Followers of Yale Professor Robert Shiller’s cyclically adjusted price earnings (CAPE) ratio will point to it as another similarity. The CAPE ratio is at 33.6, a level only exceeded during the dotcom bubble. The CAPE ratio reached a record high of 44.2 in 1999. The market topped out a few months later.
While all bull markets and bear markets are different, I thought it might be useful to see what would have happened to an investor who got into the stock market in January 2000. This hypothetical investor ignored all allocation rules and simply invested $100,000 into the Vanguard 500 Index fund (VFINX), which tracks the S&P 500 index. The chart at the right shows the portfolio’s returns.
Eighteen years later, this investor’s wealth is more than 150% greater. The large gain occurred even though two bear markets have struck within nine years after the singular investment was made. Were there down years? Yes, the portfolio fell in value before the first year was over and didn’t get back to breakeven until 2006. In 2008, the gains were reversed, and positive territory was not seen again until 2010. Yet, there was a big reward for not panicking.
This analysis is just a snapshot of history. The next bear market will likely be different than the last two ones. So will the next bull market. Nobody knows when they will happen, how long they will last or what will happen afterward. There are simply too many variables to make accurate predictions. Anyone who does correctly call the next bear market will have benefited from luck more than anything else.
Which brings me to an important question: If you’re unsure about whether now is a good time to be invested, what gives you confidence that you will know when to get into the market in the future? Furthermore, if you sat out of the current bull market at any point over the past several years, what are the odds that you’ll catch the next big buying opportunity when it emerges?
Market bottoms are always measured from market tops. The higher the top, the higher the bottom, all else being equal. At current levels, it is mathematically possible for a bear market to occur and for the Dow Jones industrial average to still be above 20,000. (A 20% drop now would put the Dow at approximately 20,800.) Could the Dow fall below 20,000? It’s within the realm of possibilities, but so is a melt up toward 30,000.
When faced with uncertainty, it’s best to go with the long-term odds. The odds favor a long-term allocation to stocks. Add in bonds and cash to the extent you need sources of income and a cushion against price volatility. Will your portfolio go up every year? No. Will you do better than trying to guess when to get in and out? Yes.
- The Investment Implications of Lower Stock Return Prospects – The guidance given in this 2001 AAII Journal article is still applicable today for those who are concerned about returns being lower in the years ahead.
- The Trinity Portfolio: Combining Diversification, Tilts and Trend-Following – Those of you who are not content with a simple buy-and-hold approach may find this approach useful.
- Insights on Using the 4% Withdrawal Rule From Its Creator – Bill Bengen revised his oft-followed withdrawal rule from 4% to 4.5%. Find out why.
- 52-Week Highs Perform Better Than Record Highs – Returns are higher when investors focus on buying stocks trading at their respective 52-week highs than at their record highs.
No changes were made to the Model Shadow Stock Portfolio.
The AAII Model Shadow Stock Portfolio lost 3.9% in December. The Vanguard Small Cap Index fund (NAESX) added 0.4% for the month, and the DFA U.S. Micro Cap fund (DFSCX) fell 1.0% in December. Even with the decline, the portfolio gained 14.0% last year.
We’ll enter the heart of earnings season with 84 members of the S&P 500 scheduled to report earnings. Included in this group are nine Dow components: Johnson & Johnson (JNJ), Procter & Gamble Co. (PG), Travelers Companies Inc. (TRV) and Verizon Communications Inc. (VZ) on Tuesday; United Technologies Corp. (UTX) and General Electric Co. (GE) on Wednesday; Caterpillar Inc. (CAT), Intel Corp. (INTC) and 3M Co. (MMM) on Thursday.
The week’s first economic reports will be the January PMI Composite Flash and December existing home sales, released on Wednesday. Thursday will feature December international trade and December new home sales. The December durable goods orders and the first estimate of fourth-quarter GDP will be released on Friday.
One Federal Reserve official will make a public appearance this week: Chicago president Charles Evans will speak on Tuesday.
The Treasury Department will auction $26 billion of two-year notes on Tuesday, $15 billion of two-year floating rate notes (FRNs) and $34 billion of five-year notes on Wednesday and $28 billion of seven-year notes on Thursday.
- Should You Maintain an Allocation to Bonds When Current Rates Are Low?
- Insights on Using the 4% Withdrawal Rule From Its Creator
- Closed-End Bond Funds Versus Individual Bonds: A Case Study
Optimism among individual investors about the short-term direction of stocks is back above 50%. The latest AAII Sentiment Survey also shows declines in neutral and bearish sentiment.
Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 5.4 percentage points to 54.1%. The rise puts optimism above 50% for the fourth time in five weeks. The historical average is 38.5%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined by 1.8 percentage points to 24.5%. Neutral sentiment is below its historical average of 31.0% for a seventh consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, pulled back by 3.7 percentage points to 21.4%. The drop puts pessimism near the lower end of its typical historical range. The historical average is 30.5%.
Bullish sentiment is above its historical average for the sixth consecutive week. This is the longest such streak since a 10-week stretch following the 2016 elections. During the current streak, optimism has averaged 51.8%.
Historically, the S&P 500 index has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings. A table with the historical data can be found on our website.
Some individual investors are encouraged by the record highs for the major indexes, the tax cuts and/or the Federal Reserve’s decision to continue raising interest rates at a gradual pace. Other individual investors are concerned about the possibility of a pullback or a more severe drop occurring. Even many investors who are optimistic about the overall direction of stocks expect a return of volatility this year. Also affecting investor sentiment are earnings growth, economic growth, valuations and the lack of volatility. Washington politics remain at the forefront of many individual investors’ minds.
This week’s special question asked AAII members what they thought would most influence the direction of stock prices in 2018. Almost one out of three respondents (31%) said taxes and/or corporate earnings. Many of these respondents expect the tax cuts to lead to higher profit growth. Approximately 29% said politics, domestically or internationally. More than 8% of all respondents mentioned President Trump by name, some favorably and some unfavorably. The Federal Reserve, interest rates and monetary policy were named by 16% of respondents. Some respondents listed more than one factor they expect to influence the market.
Here is a sampling of the responses:
- “Corporate profits and the new tax law.”
- “Tax cuts will help. Only an unexpected geopolitical event will cause a downturn.”
- “Fed activity around interest rates.”
- “Growth of worldwide economies is important, but politics with Trump could also produce a dramatic change.”
- “Animal spirits and money from the sidelines finally.”
Bullish: 54.1%, up 5.4 points
Neutral: 24.5%, down 1.8 points
Bearish: 21.4%, down 3.7 points
Local Chapter Meetings
January 11, 2018 Two Ways to Build and Preserve Wealth
January 4, 2018 Quality Can Help Put the Odds in Your Favor
December 28, 2017 19 Investing Resolutions for 2018
December 21, 2017 Value and Momentum Work Well Together