Market Highs & Sentiment Lows

On March 4, 1957, the S&P 500 began tracking 500 large US companies. Prior to that, it tracked only 90 individual stocks. In the time since then, the S&P has hit 960 new all-time highs. That equates to about one record-breaking high every 15 trading days, or every three weeks on average.

The problem with averages is that they rarely reflect actual observations. In other words, we don’t often see a new high, a pullback, followed by another high three weeks later. More likely what we experience is a long strings of new highs, followed by a market “correction”, and then a long “repair” period before the return of new highs.

So it should come as no surprise that after a drought of 57 weeks without hitting any new all-time highs (the last one was May 21, 2015), we are now seeing a string of them (ten so far) since July 11, 2016. Most of the time these periods of growth are viewed favorably and we see a rise in investor sentiment. But sometimes this pattern of new highs creates fear. Why?

Much can be explained by a behavioral finance principal called Recency Bias. This principle states that whatever happened to us most recently will color our outlook on what we expect to happen in the future. So let’s examine what about our past may be affecting our current emotions.

Following the bursting of the tech bubble and the 2008 financial crisis – two highly volatile, emotionally scarring market events that occurred within a span of eight years of each other – many investors have been skeptical of extended periods of new market highs. Only after years of repair do some investors finally feel comfortable sticking their toes back in the water. And then it seems like as soon as they do, the markets whipsaw again, like they did from mid-2015 to February 2016 when the S&P 500 fell nearly 15%. So it is easy to understand why many investors are gun-shy. But it’s important to maintain perspective on why those two volatile events occurred:

The tech bubble was the result of a massive run-up in the stock market fueled by the excitement surrounding the proliferation of the internet. At that time, most investors chased any stock that was in any way related to technology, bidding up prices to the point where stocks were extremely expensive, as evidenced by a forward price-to-earnings multiple (a common measure used to represent the relative valuation of stocks) of more than 24x, compared to a long-run average of about 16x (see chart below). We are nowhere near those levels of valuation right now. In fact, we are only slightly above the long-term average – meaning technically, stocks are not expensive nor cheap, but roughly “fairly valued”.

In contrast, the 2008 financial crisis was really a credit bubble. The combination of government pushing for higher levels of affordable home ownership, lenders pushing for more loan originations, and investors searching for higher yields resulted in easier lending standards which caused a rise in housing demand and riskier bank balance sheets.

Since the crisis, new banking rules have been written, lending standards have tightened, and banks have repaired their balance sheets considerably. In fact, 31 of the 33 largest banks in the US passed the Federal Reserve’s June 2016 stress test for a “severely adverse” economic scenario – a scenario characterized by: a severe global recession, unemployment rising to 10%, GDP falling by 6.25%, inflation rising by 1%, and stocks falling by 50%. Nearly all of the 33 banks, which represent more than 80% of US banking assets, passed this extremely grim scenario! The only two that didn’t are foreign banks with US subsidiaries.

We tell this story not to say that volatility is behind us and that there is nothing ahead but smooth sailing, but instead to provide some perspective on the scars that hold many investors back. An old adage goes: “the market climbs a wall of worry” – meaning there’s almost always something to worry about in the market. There will always be bumps along the way, but there’s generally no reason to be scared when the stock market is hitting new all-time highs. They are a natural byproduct of an economy in which companies compete and strive for constant operational improvement. Until that motivation ends, the natural course will always be (in the long run) higher.