Buying High and Selling Higher

Over the past several months we’ve witnessed a “melt-up” in stock prices as the S&P 500 has just surpassed 2,600 almost exactly a year after eclipsing 2,200 for the first time (+18%).  In previous Market Commentaries, I’ve discussed the euphoria that can sometimes foreshadow the end of bull markets.  In my book The Arrogance Cycle, I discuss how, collectively, investors sometimes behave as though history offers no guidance, and the markets will rise forever.  But even the most bullish among us knows that isn’t true.  There will be pullbacks, corrections, and, yes, one day even a bear market.  I can say these things with complete confidence and conviction.  What no one is sure about, though, is when those events will transpire.

Bull markets have been described as the triumph of greed over fear.  Indeed, there is much truth to that statement.  During the course of this 8+ year bull market, countless investors have pressed their luck by piling into the same handful of stocks that have reliably led the indices relentlessly higher.  And the greed has panned out.  But in my experience, the final stages of a bull market can actually be so powerful because they are fueled more by fear than by greed.  Well behind schedule in saving for retirement and worn down by missing out on month after month of gains, investors begin to believe that the opportunities in the stock market will be fleeting – and they panic.  We saw a similar phenomenon during the late stages of the bull market in housing.  People started to believe that if they didn’t act soon, they would be locked out of homeownership forever.  And so the relentless climb higher in stock prices could simply represent the final capitulation of the remaining fence-sitters.  The key question is how many fence-sitters remain to take the markets higher into year-end and beyond.

There is some rationality in the fear of missing out.  Numerous studies have showed that one of the most reliable predictors of future stock returns is the valuation level at the inception of an investment.  For instance, if I buy 100 shares of Coca Cola when it’s trading at a price-to-earnings (P/E) ratio of 25x, I can expect to earn lower returns over time than if I had bought the stock at 12x.  I am simply describing the first rule of investing, which is “buy low and sell high.”  But during the latter stages of a bull market, many investors fear that stocks will never be low again, and so it’s better to “buy high and sell higher” than it is to miss out altogether.

This very real dilemma is being experienced by millions of retirement savers across the country, and it is the direct result of Federal Reserve monetary policy.  The Fed’s stated policy of inflating asset prices as a means of driving economic recovery succeeded beyond its wildest expectations.  The appreciation in assets has been great for those of us who started out with a lot of assets.  But what about the masses who didn’t start out with sizeable retirement accounts.  Should they be setting aside more for retirement knowing that future asset returns will be far lower than they’ve been in the past several years?  Or should they be setting aside less knowing that stocks are riskier at today’s elevated valuations?

Emotion is the enemy of the investor.  Fear of missing out is a one of the biggest pitfalls of investing.  A more sensible approach is to do your homework and talk to your investment advisor about what happens next.  It may be true that despite historically high valuations, stocks can keep going higher…even for many more years.  But simply blindly buying for fear of missing out is not a wise investment strategy.

In closing I would just like to wish everyone a very Happy Thanksgiving!  We are thankful for all of you and your continued interest in Farr, Miller & Washington.  Please do not hesitate to contact us if you would like to discuss your investments.