The U.S. stock market has already risen 7.5% for the year and it shows no signs of slowing down. This strong start is following a 21.8% return in 2017 and a 11.9% return in 2016. In the S&P 500 Index about 140 companies have already produced a double-digit return.
By several metrics the market is trading at extreme valuations. The ratio and sentiment readings are at all-time highs. The Cyclically Adjusted PE Ratio (CAPE) is 34.75. The CAPE peaked in December of 1999 at 44.19. Prior to Black Monday, October 19, 1987 it was 18 and on the eve of the 1929 stock market crash it was 30. The AAII Index, American Association of Individual Investors, lists 54.1% of its members as bullish. The average reading for the index is 38.4%. The Citigroup Panic/Euphoria Model is flashing the euphoria warning. In September it was near panic levels.
With market and metrics peaking investors might want to sell their stocks and move the money to cash. In the short term, this may be a prudent move. Cash is a security blanket in times of uncertainty and it may provide comfort if the stock market were to fall.
The prior peak in the stock market was October 2007 when the Dow Jones closed at 14,198. After it topped it fell 54% to a low of 6,469 in March 2009. If you were able to sell at the top and buy at the bottom you’d be a legend. This probably didn’t happen to you or anybody you know. When an investor moves his money to cash to avoid a stock market correction he’ll usually buy again before it stops falling or well after it has recovered. In both cases he loses.
If you bought stocks in October 2007, a horrible time to invest, you still doubled your money at the end of 2017. A $10,000 investment in the Vanguard S&P 500 Index Fund on October 1, 2007 grew to $21,309, a gain of 113%. If you were dollar-cost-averaging by investing $1,000 monthly into this fund you gained 237% because you were buying stocks on the way down and the way up. By investing monthly your original investment grew to $272,946.
Does it make sense to sell your stocks and move your money to cash to avoid a stock market correction? Cash, as measured by the one-month US Treasury Bill, has averaged 3.4% since 1926. A $1 investment in a T-Bill in 1926 “grew” to $21 at the end of 2015. During this same time frame inflation averaged 2.9% so the return on your investment, before taxes, was .5%. By comparison, $1 invested in the S&P 500 grew to $5,386.
Since 2007 cash has had an average annual return of .7% and inflation 1.8% so you lost 1.1% per year by investing in a safe asset class.
Cash is looking more attractive as interest rates rise. The Federal Reserve is expected to raise interest rates four times this year so the rate on your cash account should rise as well. However, as interest rates rise so does inflation. The rise in inflation will always reduce the return you earn on your cash investment and when taxes are applied it’s probable your annual return will be negative.
Diversification is a better alternative for an investor with a long-term perspective. A balanced portfolio of 60% stocks and 40% bonds returned 8.4% per year for the past 31 years, a $20,000 investment is now worth $245,000. This portfolio endured four major market corrections and during the most recent one, 2008, it did fall 16%. A double-digit loss is not fun but losing 16% is much better than losing 54%.
As the market continues to rise diversify your assets, rebalance annually, invest monthly, and follow your financial plan. Your long-term goals are more important than short-term market moves.
“I am an old man and have known a great many troubles, but most of them have never happened.” ~ Mark Twain
Therefore, do not worry about tomorrow, for tomorrow will worry about itself. ~ Matthew 6:34
Bill Parrott is the President and CEO of Parrott Wealth Management an independent, fee-only, fiduciary financial planning and investment management firm in Austin, TX. For more information please visit www.parrottwealth.com.
January 27, 2018
Note: Past performance is not a guarantee of future returns. Your returns may differ than those posted in this blog and investments aren’t guaranteed.
 Morningstar Office Hypothetical Tool.
 Dimensional Funds 2016 Matrix Book
 Morningstar Office Hypothetical Tool, 12/31/1986 – 12/31/2017, Vanguard S&P 500 Index Fund and Vanguard Total Bond Fund.