What does this mean for investors? Let’s look at alternative investing approaches, including what you could do to avoid this. A few strategies you can easily deploy will make the next round trip — and, yes, there will be one — much more profitable.
First, a few words about new all-time highs.
Ned Davis Research did a study (brought to my attention by Mark Hulbert) that looked at what happened when the S&P 500 made a new market high after a bear market. Since the 1950s, there were 13 such instances. The mean bull market “continued for another 644 days — nearly two years — and, in the process, gained an additional 40.3 percent.” The median case was less impressive — the bull ran for one more year and gained more than 18 percent.
The weakest example was 2007, with the inflection point coming less than six months later and under 3 percent higher following new highs.
Why is this noteworthy? Mostly because so many investors have fought this rally the entire way up. I suspect the recency effect is to blame — the residual psychological trauma caused by the 2008-09 crash is still so fresh in people’s minds that they have become fearful of risk. Aversion to losses has investors so focused on avoiding any drawdown that they end up missing what turns out to be the best rally in a generation. New highs raise the fear of yet another market top.
This is an emotional reaction. Rather than give in to your ancient lizard brain, let’s put that big ole underutilized neocortex to work. To do that, we have to consider a few standard market metrics and see whether they tell us anything.
Valuation: Markets today are not cheap or expensive. Despite doubling since the market lows, the S&P 500 trades at 15.4 times earnings. The average for all bull markets since 1962, according to Bloomberg, is just under 20 times earnings. From a valuation perspective, markets are not unreasonably priced.
Market internals: Healthy markets can be described as having a strong trend, good leadership and, especially, good breadth. What that last term means is that many stocks are participating in the overall market trend. We track this through the advance-decline (A/D) line, a measure of how many stocks are rising versus falling. During market tops, we tend to see new highs made even as the A/D line diverges. This happens because major market tops are usually preceded by signs of increasingly selective buying. Think of the Nifty Fifty in the 1970s or the four horsemen of the Internet in the late 1990s. I also watch how many new 52-week highs are being made versus new lows. When this diverges from prices, it can be a warning sign.