Time and time again professionals in the investment field use quick and easy optical demonstrations of market behavior in order to influence action. A classic example is this graph:
Source: unknown; included in a friend’s email
It portrays the extent and duration of all the Dow Industrial Average rallies (after a fall of 30% or greater) since 1900. The visual conclusion is that the current rally, from the bottom in 2009, is not even of average duration. The implication: this bull market run could continue for quite some time.
And indeed it could, just like you could hit an outrageous consecutive streak of heads or tails. But if you are an investor, you need to find something a little more solid before you take a decision. You could, for example, look at where valuation was at the beginning of a rally, since we know that short-term market movements are close to random but long-term moves are linked to the value of what you buy.
To help you find where a popular valuation metric was at the dates highlighted in the above graph, here’s the history of the Shiller price/earnings ratio for the past 134 years:
Note that all indicated starting dates in the first graph (1903, 1907, 1921, 1933, 1942, 1974, 1987, and 2002) have Shiller P/E’s from moderately to substantially below the current level of 27.15, which itself is higher than most historically important peaks (except for 1929, 2000 and just before the most recent financial crisis).
You could also look at the ranges of stock market returns given certain initial valuation levels. Crestmont Research did the analysis (“Generation Returns”); in particular, look at the table at lower right, which covers the period 1900-2013. Focus on the second-to-last column, and notice how the higher the P/E ratio is at the beginning of the period, the lower the average return of the S&P 500 is in the subsequent 20-year periods (third-to-last column). If you start from today’s levels of P/E, which is about 42% higher than the average of the most expensive decile listed in the table, you would have to question the wisdom of staying in this market. (Methodological note: Shiller’s P/E and Crestmont’s P/E are not identical but they are very similar in their historical behavior.)
Today’s market, just as any other market, should be viewed in the context of valuation levels, not on how many months it has lasted. You wouldn’t use the same cooking time for all the dishes you are serving at a dinner party, would you? So why on earth would you look at the duration of a stock market rally as your justification to act?
Photo Source: mentalfloss.com, thinkstock