Are Stocks Heading for a Fall?

Investment Planning

You may have read that well-known stock indices in the US and Europe have reached new highs in recent months. Is a new market high an indication that it is time for investors to cash out?

History tells us that a market index being at an all-time high generally does not provide actionable information for investors. For evidence, we can look at the performance of the MSCI World Index for the better part of the last half-century.

From 1970 to 2016 (see Exhibit 1), the proportion of annual returns that have been positive after a new monthly high is similar to the proportion that have been positive after any index level.

Investment Planning

In fact, almost a third of the monthly observations were new closing highs. Looking at this data, it is clear that new index highs were not useful predictors of future returns.

So, if the level of an index by itself does not have a bearing on future returns, what does?

One way to compute the current value of an investment is to estimate its future cash flows and calculate their value today. This type of valuation method allows expectations about a firm’s future profits to be linked to its current stock price through a “discount rate”. This rate is equal to an investor’s expected return. This valuation method tells us that the expected return from holding a stock is driven by a combination of the price paid for it and what its investors expect to receive.

Stock prices are the result of the interactions of many willing buyers and sellers. If investors apply positive discount rates to the cash flows they expect to receive from owning a stock, they should expect the price of that stock to represent a level such that its expected return is positive. It is extremely unlikely that, in aggregate, willing buyers of stock apply negative discount rates to the expected profits of the firms they are purchasing. If they did, it would imply they collectively expect a negative return on investment. If this were the case, why would they buy at all?

Therefore, it is reasonable to assume that the price of a stock, or the price of a basket of stocks like the MSCI World Index, should be set to a level at which its expected return is positive, regardless of whether or not that price level is at a new high.

It is important to make the distinction between expected and realised returns. The latter may be negative or positive because of changes in expectations. If either expected returns or expectations about future profits change, prices will also change to reflect this new information. Changes in risk aversion, tastes and preferences, expectations about future profits, or the quantity of risk can all drive changes in expected returns.

This all helps explain why new index highs have not, on average, been followed by negative returns. At a new high, a new low or something in between, expected returns are positive.

Share and Follow us:

Share on linkedin
Share on facebook
Share on twitter
Share on email
Share on print
Share on whatsapp

Why not sign up to our regular updates

Just add your email address and we’ll add you to our email list. You can unsubscribe any time

Other posts you might find useful

global investment outlook
Investment

Long-Term Investing

March 2020 will long be remembered as a month when information overload was tested beyond imagination. Embattled investors had to deal, not only with an imminent threat to life against themselves and their families, but

Read More »
Corona Virus and Stockmarkets
Investment

Market Volatility and the virus

Long term investment principles The world is watching with concern the spread of the new coronavirus. The uncertainty is being felt around the globe, and it is unsettling on a human level as well as

Read More »
global investment outlook
Investment commentary

Global Investment Outlook 2020

Our thoughts for 2020 Two thousand and nineteen has overall produced strong returns for investors even though volatility increased in equity and bond markets over the year. We are currently in one of the longest

Read More »
commercial property
Investment

Property Fund Suspension

Not another fund suspension! Earlier this week we had yet again an announcement of a temporary fund suspension from one of the leading property fund managers in the UK. M&G Investments announced the temporary suspension

Read More »