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What Happens After a Big Market Gain?

It seems lately that I am hearing more people ask, "The market is at an all-time high, should I sell? When is the correction coming?" I am curious as to why the question is being asked. Is it a matter of frame dependence? Is it human nature? Is it too much CNBC? I suppose it is only natural to question the sustainability of rising stock prices, given what the market has done in the last five years. The question now is: Historically, how has the market performed after a big gain? Below is a table that summarizes the performance of the S&P 500 Total Return Index since the beginning of 1970 through August 31, 2014. I looked at all of the five year annualized returns and analyzed the five year periods that immediately followed a five year annualized return of 20% or more. 

The above results tell me that the returns of the market are, on average, lower after five year periods where the market has experienced a big gain. However, these returns are generally still positive. After the great performance that we have experienced over the past five years - the S&P 500 averaged more than 16% per year - it seems only reasonable that these above average returns will not continue indefinitely. Does this mean we should act in some fashion now to shelter gains and prepare for a downturn? Absolutely not. Remaining focused on your long-term objective(s) is the best strategy.

A correction is defined as a temporary 10% decline in the market. You have heard us say before, there is no way to consistently predict or time a market correction. As Bob always says, "Corrections always happen with unpredictable regularity." On average, market corrections occur about once a year. Truth be told, we have not seen a market correction since the decline that ended in 2011.

Looking at the bigger picture, I am positive about stocks in the US for a number of reasons.

  • Primarily, the level of interest rates remains relatively low, for the time being. In many instances you have to buy a bond with a maturity greater than 10-years to get a yield that is higher than the dividend yield of many of the stocks we own now. Furthermore, credit spreads, which are the difference between Treasury bonds and higher yielding corporate bonds, are rather narrow, indicating that the credit markets are confident about the economy's health. 
  • Many US companies emerged from the financial crisis leaner, financially stronger and more competitive than they were pre-crisis. As a result, high levels of profitability have driven the cash balances of many of these companies to record levels. Some companies have conservatively used the cash balances to repurchase shares of the company stock and/or increase dividend payouts to shareholders.
  • The overall market, from a relative valuation standpoint, has increased from the lows seen in the financial crisis and is now closer to historical averages. Looking at the valuation levels of past market cycles, we are well-below peak levels. Simply put, stocks aren't as cheap as they used to be, but there are still opportunities available.

When major market indices reach new heights, some investors may become understandably wary. The important thing is to remember your long-term objectives and not let your emotions control your investment decisions. 

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