Investment Considerations at All-Time Highs
We have all had to find ways to keep ourselves entertained in the past year through handling quarantine and the virus. Maybe at one point you found yourself with nothing better to do but flip a coin to test your skill in guessing whether the result was heads or tails. Although now this seems like a ridiculous thing to spend time doing, there was a point in time during quarantine where all bets were off. If you were to flip a coin repeatedly, inevitably at some point a seemingly discernable pattern would break out, which may have caused you to guess “tails” after a series of three or four heads in a row. Of course the result of the last flip does not have influence on the next flip, but it is tempting to assume that based on the 50/50 chance of heads or tails that a consecutive string of heads would result in the next flip showing tails. This is known as the gambler’s fallacy, and in several ways investors at times may be prone to forming opinions on the market purely as a result of succumbing to this fallacy, with respect to future return expectations based solely on recent performance.
The gambler’s fallacy, or otherwise known as the Monte Carlo fallacy, is described as an erroneous belief that a “certain random event is “less likely or more likely to happen based on the outcome of a previous event or series of events. This line of thinking is incorrect, since past events do not change the probability that certain events will occur in the future”. [1] As far as this relates to the market, we have recently touched all time highs across benchmarks on a number of different trading days. Considering the fact that we are still in the midst of the pandemic, inflation fears, soaring housing prices, soaring commodity prices, along with a handful of other inputs, the rationale that the market needs to catch up to its current valuation is not baseless.
Current valuation of the S&P 500 as of March 31st, 2021 is more than one standard deviation above the typical premium on a forward-looking basis [2], but it is crucial to recognize the strength of the recent earnings season from the first quarter. According to data from StreetInsider, 87 percent of companies who have reported for the first quarter have exceeded analyst expectations. [3] This is significant due to the fact that in an earnings beat, the share price premium is effectively diminished due to earnings increasing, i.e. increasing the denominator in the price-to-earnings ratio that is used to determine the relative value of a company’s shares at a given point in time.
As time passes, parallels in differing market conditions throughout time can be drawn. The market does not perfectly repeat itself, but it often rhymes. Jordan Jackson, Global Market Strategist for JP Morgan describes this well within the context of the market hitting new highs:
“For many DIYers and other retail investors, as the market continues to hit new all-time highs, it’s likely they may want to pull back on risk even further. However, history suggests that now may be just as good as any to put cash to work in the market – especially if you’re investing for the long run like retirement. As shown, if you invested in the S&P 500 on any random day since the start of 1988, on average, your one year total return was +11.9%. Perhaps somewhat surprisingly, if we only consider investments on days when the S&P 500 closed at an all-time high, your average one year total return was +14.3%. Moreover, if we look at cumulative total returns three or five years out, the takeaway is the same.”[4]
Currently, a focal point in markets is the proposal to raise capital gains taxes from 20% to 43.4% for high earners in the United States ($1MM+). Continuing within the framework of market history, the market has typically had the ability to look past capital gains increases. There is some time before any changes are finalized, and it is likely that the 43.4% is reduced to a lower figure as it is negotiated by congress. We must also recognize the fact that this increase, regardless of the eventual percentage rate it will amount to, is at the heels of mammoth fiscal and monetary stimulus that was pumped into the economy.
Drilling down into the market’s historical reaction to tax hikes, as Chisholm research finds, “on the 13 previous instances of tax increases just since 1950, the S&P 500 has shown higher average returns, and higher odds of an advance, in times when taxes are increasing.” [5] This study analyzed data in the calendar year of the tax changes, plus the year prior and year after. Each instance in which taxes were increase of course involved different economic variables, but the fact that increases take time to take effect, coupled with the spending that accompanies increases has allowed markets to overcome the potential hurdles that tax hikes can impose on earnings, margins, and net personal income, depending on the type of tax hike that is at play.
Ultimately, there are a number of obstacles the market must overcome to continue its trend upward beyond the proposed capital gains tax increase. The market must grow into its current valuation otherwise we risk overheating. The high percentage of companies exceeding expectations in first quarter earnings helps this dramatically. Still, we are in a peculiar phase of emerging from the COVID recession. Robert Phipps, director at Per Stirling Capital Management described our current scenario well: “We have sentiment levels and valuations of a very old, mature bull market. But we have monetary and fiscal policies of a young, emerging bull market, and an economy just coming out of a recession.”[6]
Disclosures & Sources:
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often neutered for investments in emerging markets. Asset allocation does not ensure a profit or protect against a loss.
Investing in mutual funds involves risk, including possible loss of principal. Find value will fluctuate with market conditions and it may not achieve its investment objective.
Stock investing includes risks, including fluctuating prices and loss of principal. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect principal.
The economic forecasts set forth in this material may not em develop as predicted and there can be no guarantee that strategies promoted will be successful.
Content in this material is for general information only and is not indebted to provide specific advice or recommendation for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The Financial Consultants at Vintage Wealth Advisors are registered representatives with, and securities offered through, LPL Financial, Member FINRA/SIPC. Investment advice and financial planning offered through Financial Advocates Investment Management, DBA Vintage Wealth Advisors, a registered investment advisor. Financial Advocates Investment Management, Vintage Wealth Advisors, and LPL Financial are separate entities.
StreetInsider - First Quarter 2021 Earnings Beat/Miss Report
JP Morgan Guide to the Markets, Second Quarter 2021
JP Morgan Chase - Market Insights, Updates on the Minds of Investors - DIYers and All Time Highs
NewsFilter -This Bull Market is Far From Over - Robert Phipps, Per Stirling Capital Management