S&P's byes at the highs
Technical analysis is absolutely clear on this clear on this point: fresh all-time highs are bullish. Indeed, a popular saying among traders is “new high, new buy.” The straightforward logic is that once a price enters ‘blue-sky territory’ there are obviously no past price levels standing in its way. The breakout is worth buying, therefore, in anticipation of continued gains.
Nevertheless, many investors get nervous when an index hits all-time high. Particularly to those of a contrarian mindset, the idea of buying the S&P 500 today at unprecedented levels after a five-year boom must seem counterintuitive. After all, wasn’t the market at all-time high in 1929, 1987, 2000 and 2007, just before it suffered some of the most savage sell-offs in history?
Rather than rely on folk wisdom or gut-feelings, I have taken a look back at the S&P’s historical performance in the wake of fresh monthly closing highs. Going back to 1928, there have been 174 months in which the market has ended a month at a record high. The returns from buying at the opening price of the following session are shown in this table.
|% returns after…||1m||3m||6m||12m|
|All other times||0.54||1.73||3.49||7.25|
On average, the market has done slightly better following all-time highs than it has done at other times. This is especially true over 3 to 6 month horizons, where the average return has been some 0.4 and 0.6 per cent higher.
|% probability of gains||1m||3m||6m||12m|
|All other times||58.5||60.4||63.9||67.2|
The likelihood of further gains is also greater following a new peak in the market. Once again, the most significant period has been the next 3 to 6 months. Over a three-month horizon, the S&P has gone up a bit more than 70 per cent of the time following a record reading, compared to only around 60 per cent for other three-month periods.
|Average worst loss (%)||Within 1m||Within 3m||Within 6m||Within 12m|
|All other times||-3.53||-6.19||-8.73||-11.95|
What about when the market has fallen in the wake of record highs? The accompanying table displays the average decline in the S&P at its lowest intraday level following an all-time high. In all cases, the market’s average worst falls were lower than at other times. One year later, for example, the average worst decline was 9.4% after a record high, against 11.9% at other times.
|Worst drawdown (%)||Within 1m||Within 3m||Within 6m||Within 12m|
|All other times||-32.7||-46.5||-52.3||-70.8|
Of course, the drawback of averaging is that it can obscure some pretty extreme events. Therefore, I’ve also looked at the maximum peak-to-trough price declines suffered after the index made history on the upside. The worst 1-, 3-, 6-, and 12-month declines of all came after times other than record highs.
Admittedly, record price highs do not necessarily tell us anything about the value inherent in the market at that level. My preferred measure of valuation is the Cyclically Adjusted Price Earnings ratio (CAPE), which compares the S&P 500 to its which I have found to be more predictive of subsequent real total returns than many other popular metrics.
Today, the S&P 500 trades on more than 25 times its average, inflation-adjusted earnings of the last decade. This is well above its historic mean and median ratings of 16.5 and 15.9 respectively. At past price highs, it has variously traded on ratings of less than 10.6 and greater than 30. How has this impacted subsequent return performance?
Logic suggests that the best of all worlds would be a combination of all-time highs and a low or modest CAPE. I have therefore sorted the one-year returns that followed a record index-peak according to their valuations at those price peaks. As it turns out, all-time highs accompanied by cheapness are associated with further price gains over a one-year view. So far, so good.
As it turns out, though, record price highs alongside lofty valuations like today’s have not been associated with poor one-year returns to come, except when CAPE hit unprecedented levels above 40.6 at the height of the internet mania. Based on history, therefore, there is a decent chance of low decent double-digit returns on a twelve-month view.
|CAPE||Ave 1yr return (%)||Gain prob (%)||Ave worst loss (%)|
These results certainly suggest that new all-time highs are a reason to be optimistic, rather than cautious, about the outlook in the near future, particularly over 3 to 6 months. That being the case, there is every reason for tactically-minded investors to keep faith with the S&P’s bull market for now and to stay long.