(Posted September 25, 2014)
Given the impressive returns for the S&P 500 since the 2009 bottom (the stock market bottom was March 9, 2009), the question is often asked, “What would your returns be like if you had bought at the peak of the market in 2000?”
The S&P 500 peaked on March 24, 2000. Using the S&P 500 ETF (symbol SPY) as the investable proxy for the market, the dividend-adjusted close according to Yahoo Finance was $117.43 (data is adjusted using appropriate split and dividend multipliers, adhering to Center for Research in Security Prices (CRSP) standards).
As of yesterday’s close of $199.56 for SPY (September 24, 2014), we have an absolute gain of 29.96% over the past 14.5 years. In annualized terms, the S&P 500 has only returned 1.82% per year since the 2000 top. Note that this does not take inflation into consideration. Using this online inflation calculator, a quick look since 2000 indicates cumulative inflation was 38.1% from 2000 to 2014. so in real inflation-adjusted returns, stocks have actually lost money since the 2000 top.
Well, Debbie Downer, what if you had invested instead at the bottom of the market?
The S&P 500 bottomed on March 9, 2009, when SPY closed at a dividend-adjusted price of $60.48. As of yesterday’s close of $199.56 for SPY, we have an absolute gain of 230.0%. In annualized terms, the S&P 500 has returned 24.0% per year since the 2009 bottom.
The lesson here is two-fold:
1. Buying stocks during periods of euphoria can result in depressed returns over time.
2. Buying stocks during periods of panic can result in elevated returns over time.
Okay then, how can we tell if we’re in periods of euphoria or panic?
One simple metric we can use is a “technical indicator” called the RSI, which stands for Relative Strength Index (learn more about RSI here). Investors, traders, and even the Federal Reserve use technical analysis to better gauge the behavior of financial markets. Basically, the RSI measures levels of euphoria or panic by measuring the speed at which markets are rising or falling, with values ranging between 0 to 100. The general interpretation for the RSI is that values below 30 are “oversold” and values above 70 are “overbought.”
Note how this indicator worked remarkably well in helping identify the extremes in the markets: the indicator hit oversold levels in 2002, overbought levels in 2007, and another oversold reading in 2009. Currently, the SPY is in overbought territory, but as any experienced trader can tell you, markets can stay overbought for extended periods of time.
It is where an enormous amount of money can be made and lost, since periods of excitement can drive further excitement, a self-fulfilling prophecy of sorts where higher prices trigger more buying. But as history has shown, when markets do turn after extended runs, the future returns can be quite disappointing.
For a different perspective, we can look at the Shiller PE Ratio, also known as the CAPE (Cyclically Adjusted Price-Earnings) Ratio, a measure that looks at the valuation of the stock market, normalized over 10 years, or the course of about two business cycles (the average cycle is about 5.5 years. See more here).
Given the sharp advances of the market since 2009, its readings for both the RSI and CAPE ratio are now elevated. Historically, it suggests future US stock market returns may be uninspiring. It’s important to remember that the US stock market is not the only “game in town.” There are always investable opportunities elsewhere, whether it’s a different asset class like bonds, or non-US stocks, to name a few. It’s a matter of being able to look at the bigger picture, and having an experienced investment manager can aid in that process.
Finally, if there is a third lesson that could be added to the ones above, it is this: have a process to protect your wealth after extended gains.
Our Relative Risk Model, which aims to protect gains by moving into bonds when the risk of stocks is rising, still would have returned, on a simulated basis, about 9.6% annually even if someone had invested at the peak of the market in 2000. This is because it moved to protect one’s wealth once it saw the risk of stocks rising, by moving into bonds in late 2000, thereby mitigating losses experienced over the next two years in the stock market once the dot-com bubble burst. It’s also worth noting that this simulated model also moved into bonds about a half year before the 2008 Financial Crisis fully unfolded, which also contributed to the favorable returns. The model isn’t perfect, however, since it moved into bonds shortly after the US lost its AAA credit rating in 2011, when the risk of stocks began to rise. But it moved back into stocks in early 2012, and it has stayed with its stock allocation since then, participating in the recent record advances. The primary aim of this model is to protect your wealth while enabling one to participate in the advances of the stock market.
We don’t know when this advance in the market will end, but we do have a process in place to protect our clients’ wealth if it ever does. Do you have one?
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Rainier Trinidad, CFA
San Diego and Coronado’s Fiduciary Financial Advisor
Parabolic Asset Management
206 J Avenue
Coronado, CA 92118
Investment Risk Disclaimers: (i) Investments involve risk and are not guaranteed to appreciate, and (ii) Past performance is no guarantee of future results.