Is the Stock Market Too Expensive?

By: Andrew J. Willms

President and CEO of The Milwaukee Company

I recently had the pleasure of speaking to a former college instructor of mine about his investments. I shared my thoughts about the advantages of index tracking ETFs, the benefits of rules-based, academically-sound investment strategies, and the importance of keeping costs low. He then mentioned he had been sitting on a sizable amount of cash for some time because he didn’t want to buy stocks when prices were near all-time highs. Sound familiar?

When looked at from a historical perspective, stocks have gotten expensive by just about any measure.

  • The S&P 500, the Dow, and the Nasdaq 100 have consistently been trading at or near all time highs.

  • The S&P 500 rose 11.7% in the 4th quarter of 2021, leaving it almost 68% above its March 23 bottom.

  • The CAPE ratio, which compares stock prices to the S&P’s members’ inflation-adjusted earnings over the past 10 years, has been flirting with its highest level since the 2000 tech bubble and has surpassed its peak just before the 1929 market crash.

  • As of last Thursday, January 14, the so-called “Buffet Indicator” that divides the market cap of all U.S. stocks by GDP, recently reached 175%, close to a record high

Given all that, it would seem my friend should keep some cash on the sidelines until there is a long overdue correction, right? Maybe not.

The fact is that when the stock market is at an all-time high, more times than not it will go still higher.

JP Morgan compared the returns that would have been generated over the last 30 years if (i) the date an investor put his cash to work was determined randomly, or (i) he invested only when the stock market was at an all-time high. The following table summarizes their findings:

I bet you didn’t see that coming (I know I didn’t). Does this mean when the market hits an all-time high, you should “Buy! Buy! Buy!”, as CNBC’s Jim Cramer might say? If only investing were that easy.

High prices matter when buying stocks because even though the odds may favor stocks going still higher, the risks associated with a market sell-off also increase. Simply put, the more you pay, the more you stand to lose if the market changes course.

It can take years to recover losses that can occur if you are unlucky enough to invest at a peak that is followed by a significant downturn. One study found that in the 90 years between 1928 and 2018, there were only four times when it took more than five years for the S&P 500 to get back to its previous high. But those unfortunate investors who had the misfortune to invest at the high that preceded the Great Depression would have had to wait 25 years just to get back to square one.

Maybe you’re thinking you can live with those odds. But the reality is that the time it takes to recover doesn’t matter if you sell before the recovery takes hold. And the truth of the matter is, most of us don’t handle losses in real time as well as we think we will.

So, what’s my friend whose sitting on a pile of cash to do? That depends, in no small measure on his investment horizon and tolerance for risk. Long-term investors who can turn a blind eye to a major sell-off shortly after investing a large sum are in the best position to invest a lump sum. Then again, not many people are members of that exclusive club.

For the rest of us, using dollar-cost-averaging (DCA) can be a sound alternative. Legendary investor and author Benjamin Graham, who was an early proponent of DCA, explained how it works:

“Dollar-cost averaging … means simply that the practitioner invests in common stocks the same number of dollars each month or each quarter. In this way he buys more shares when the market is low than when it is high, and he is likely to end up with a satisfactory overall price for all his holdings.”

A recent study published in the CFA Institute found that while lump-sum investing offers higher expected returns than DCA, DCA does a good job of lowering downside risk.

“Volatility, or standard deviation, decreases with DCA and the difference grows with time. DCA’s benefits are especially clear with the bottom decile and worst returns, which follow a similar pattern…. So immediate investing generally produces higher returns, but with more risk, especially on the downside.”

In sum, all-time highs are no reason to delay putting cash to work in the market. Waiting means foregoing the power of compounding, and likely means you will end up paying higher prices when you do pull the trigger. That said, we’re all familiar with the old adage: patience is a virtue. DCA is a good way to be virtuous.

Thank you for reading.

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