Here’s a common misconception I’ve noticed that investors have about the stock market: They think that it’s easy to figure out when stocks will hit a peak. Unfortunately, that’s not an easy task at all.
In a 2017 Bloomberg article, investor Ben Carlson showed the level of various financial data that were found at the start of each of the 15 bear markets that US stocks have experienced since World War II:
The financial data that Carlson presented include valuations for US stocks (the trailing P/E ratio, the cyclically adjusted P/E ratio, and the dividend yield), interest rates (the 10 year treasury yield), and the inflation rate. These are major things that the financial media and many investors pay attention to. (The cyclically-adjusted P/E ratio is calculated by dividing a stock’s price with the 10-year average of its inflation-adjusted earnings.)
But these numbers are not useful in helping us determine when stocks will peak. Bear markets have started when valuations, interest rates, and inflation were high as well as low. This is why it’s so tough to tell when stocks will fall.
None of the above is meant to say that we should ignore valuations or other important financial data. For instance, the starting valuation for stocks does have a heavy say on their eventual long-term return. This is shown in the chart below. It uses data from economist Robert Shiller on the S&P 500 from 1871 to 2019 and shows the returns of the index against its starting valuation for 10-year holding periods. It’s clear that the S&P 500 has historically produced higher returns when it was cheap compared to when it was expensive.
But even then, the dispersion in 10-year returns for the S&P 500 can be huge for a given valuation level. Right now, the S&P 500 has a cyclically-adjusted P/E ratio of around 31. The table below shows the 10-year annual returns that the index has historically produced whenever it had a CAPE ratio of more than 25.
If it’s so hard for us to tell when bear markets will occur, what can we do as investors? It’s simple: We can stay invested. Despite the occurrence of numerous bear markets since World War II, the US stock market has still increased by 228,417% (after dividends) from 1945 to 2019. That’s a solid return of 11.0% per year. Yes, bear markets will hurt psychologically. But we can lessen the pain significantly if we think of them as an admission fee for worthwhile long-term returns instead of a fine by the market-gods.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.