How to Invest When the S&P 500 Is at All-Time Highs

When stocks hit new highs, only one of two events can follow: Stocks can either go on to make a new high, or they can decline. Given that the S&P 500 has just raced to all-time highs, these two prospects have many investors unsure of how to proceed today.

But is there a better way to think about investing at what might be a high-water mark?

Depending on how heavily you’ve invested in the stock market, you may view new highs with excitement. But for many, a new high is met with trepidation. For those investors, there’s a sense that the market is overvalued and, like a hot-air balloon, will inevitably come back down to earth — sometimes faster than they’d like. I hear this most often from those who are either not currently invested or aren’t invested heavily enough in stocks and are worried they’ll be getting in at the top, as well as investors who have been in the market for a while and worry that it may be time to lock in some gains.

To put some numbers on it, take a look at Vanguard 500 Index Fund (MUTF:VFINX) — the S&P 500-tracking fund that gives investors access to Apple Inc. (NASDAQ:AAPL), Exxon Mobil Corporation (NYSE:XOM) and the rest of the gang. VFINX gained 13.5% in 2014, hitting 57 new highs along the way. Now it’s sitting back at all-time highs.

And yet, investors seem scared.

Why Investors Fear the Peaks

Investors are struggling with two concerns here. One has to do with the question of whether stock market values have gotten too high and are poised to revert to the mean — that the pendulum will swing the other way. The other deals with how one should approach investing when markets are at or near all-time highs.

You’ve heard me say it before, but it all comes down to earnings and interest rates. We can all flap our gums about jobs and housing starts and consumer confidence and the like. But when it all gets to be too much, simplify.

Interest rates are low, and they’ll stay that way for a long time. Even when the Fed starts lifting short-term rates, there’s no reason to believe that long-term rates will go sky-high unless we get some serious inflation. So far that’s not in the cards. That’s a positive for U.S. stocks, which compete for investors’ dollars with bonds.

I think the bigger issue is whether profits keep growing, and at what rate. Profit margins have been healthy, but much of that has been a bit of earnings engineering and cost-cutting. What we need to see is more top-line growth. If that can be revved up, then the bottom line should follow.

While earnings are a basic metric by which stock values are often measured, it’s a tricky business, as there are seemingly endless ways to “value” a stock. There are multiple ways to measure earnings, and some investors prefer to look at corporate sales or cash flows or book values or even GDP — the list goes on. Vanguard’s research team has looked at myriad valuation metrics and concluded that not a single one has even a 50% chance of predicting where the stock market will be in the not-too-distant future. And still, without getting hung up on any one valuation ratio, it’s fair to say that today’s U.S. stock market is not cheap (though whether it’s expensive is hard to tell).

One thing we know for sure as 2015 dawns is that we can’t buy at 2009’s low, low valuations today. As investors, we have to deal with the here and now — stocks aren’t as cheap as they once were.

So what’s an investor to do?

How Investors Should Move Forward

In short, if you aren’t invested or are currently invested but have some new money on hand (say, from a year-end bonus), I recommend that you put that money to work. If you are already invested and have a long-term strategy working for you, stick with it.

I understand that no one wants to buy at a market top, but saying you won’t invest because the market is at a top and about to crash is plain market-timing. If you can correctly time the market, there are great gains to be made or losses avoided — but it is incredibly difficult to do, and I don’t know of anyone who has done it consistently. Investors’ saving grace: A long time horizon and disciplined strategy can overcome unlucky timing.

But as the market keeps hitting highs, it’s worth repeating. And an example is a good way to do it. Consider an investor who had the misfortune of buying Vanguard 500 Index on the Friday before Black Monday (Oct. 19, 1987) when the index fund dropped 20.5% in a day. If that investor didn’t panic and sell, he would have had a gain of 2.1% one year later, and a total gain of 19.3% three years later.

This investor came out alright in the end, because time in the markets and a consistent strategy made up for incredibly bad timing.

Or consider the charts below of long-term real total returns of U.S. stocks since 1926 and 1971—those are returns that include reinvestment of dividends and an adjustment for inflation. I have broken the data in half so that you can see greater detail in each time period, but both charts tell the same story. Stocks have historically moved in a stair-step pattern, where losses occur but are recovered and then surpassed. As you can see, there have been some stretches like the 1930s, ’40s, ’70s and 2000s, where stocks moved sideways. There have also been long periods like the 1920s, ’50s, ’60s, ’80s and ’90s, where stocks went on to make new high after new high without a major decline.

20150211-early-years-stair-step20150211-stair-step-continues

Notice that this stair-step pattern applies to short time periods as well as the very long run. The chart below shows the growth of Vanguard 500 Index (reinvesting dividends) over the past three years. Vanguard 500 Index returned 73.8% over this stretch (15.8% in 2011, 32.2% in 2013 and 13.5% in 2014), but it wasn’t all smooth sailing in a straight line — markets just don’t behave that way.

20150211-stair-step-typify-gains

Going back to the long-term charts, you might ask if we have entered a period where the markets will continue making successive new highs. I don’t know, and no one else will know, either, until after the fact.

What I do know is that at some point there will be another correction and even a bear market — guaranteed. It has been roughly three years since we’ve seen a 10% correction, so one certainly feels overdue. But, this isn’t something to fear. As Morgan Housel aptly put it in a Dec. 5 Wall Street Journal article, “All past market crashes are viewed as opportunities, but all future market crashes are viewed as risks.”

If we recognize ahead of time that tomorrow’s correction will become yesterday’s opportunity, we will be better able to weather those inevitable corrections, and maybe even take advantage of them.

The price you pay is important, and given that U.S. stocks are not cheap, I wouldn’t expect the pace of returns we’ve seen recently to continue over the next five years — Vanguard 500 Index has improved 15.3% a year over the five years through the end of 2014. If you are looking for cheaper stocks, many foreign stock markets look more attractively priced than the U.S. market.

Whether you choose to invest in U.S. stocks, foreign stocks or both, the important thing is that you do invest. If you don’t, I can also guarantee that you won’t benefit from any gains 10, 20 or 30 years down the road.

If you’ve got time on your side and expect the future to be brighter than it is today, the time to invest is when you can.

Daniel P. Wiener is editor of The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.


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