Dow Jones Hits Record High – What to do?

Recently, the Dow Jones Industrial Average hit a new all-time high, breaking the previous peak that was established in 2007.  Should an investor sell, hold, or buy? 

Everyone knows that the key to successful investing is buying low and selling high. This is unquestionably true.  However, the historical trend of the stock market has been up, which means that new highs have been achieved all along the way.  Therefore, it stands to reason that if an investor sells every time the stock market hits a new high, it may be difficult to achieve long-term profits. 

High Compared to What?

Yes, if stocks are high, you want to sell.  However, the question is high compared to what?  As an investor, should you consider past prices and market patterns, stock valuations, or other potential investment options when determining the appropriate time to sell? 

Past Prices and Market Patterns

Most investors instinctively compare prices today with where they have been in the past.  This is similar to driving a car by only looking in the rear view mirror.  While interesting, it gives you no more insight into the road ahead than a Magic 8 Ball that proclaims “Reply hazy, try again”.

What about patterns?  Investors may recall what happened the last time the market hit a new high. The market went up another 15% or so over the next year and then proceeded to lose more than half of its value during the following eighteen months.  It is certainly appropriate that we might be worried that the market again has little room left to run and is ripe for a sharp decline, as in 2008-09.

The problem with looking at past prices or patterns and extrapolating them into the present is that times are different.  The cause and the timing of the market’s decline beginning in 2008 will likely have little resemblance to any potential decline in the future. The problems encountered by the financial industry, the regulatory environment, and the economy in general have been addressed. The factors influencing the next market decline will likely look and feel very different, making it difficult to predict with any degree of certainty a future market pattern. 

Stock Valuations

It is prudent to look at companies today and compare them to where they stood five years ago.  When we do, we see that companies are in better financial shape because they have stronger balance sheets.  This is due to carrying significant amounts of cash and to debt that has been restructured or refinanced at historically low interest rates.  In addition, companies have made themselves relatively lean on the cost side and have grown earnings well beyond their previous highs.  

So, what about stock valuations, is that a good predictor of a time to sell?  If the price of a stock compared to its earnings is historically high (P/E ratio), then that may be a reasonable signal to sell.  As of year-end 2012, the P/E ratio of the S&P 500 was 12.5 (source: Standard & Poor’s). However, the 15-year average is 16.7 (source: JPMorgan, Standard & Poor’s).  Based on this valuation measure, stocks are 25% cheaper than the average over the past 15 years. 

Since there are multiple valuation measures, there are multiple opinions.  Another such measure that looks at 10-year earnings compared to prices is the S&P 500 Shiller Cyclically Adjusted P/E.  This number, which was at 21.1, is about 11% above the long-term average of 19, suggesting a slight overvaluation (source: S&P, Shiller, and JPMorgan). 

You can look at many different valuation measures.  Most of them suggest the market is reasonably valued, or perhaps slightly over/undervalued, but not significantly overvalued.  Therefore, at this time, valuation measures are probably not a reason to sell.

Other Investment Options

Compared to other investment options, where do stocks prices stand?  The following lists some of the more popular investment options along with their income yields. (source: Bloomberg.com, March 14, 2013)

• U.S. Treasury 10-year Bonds yield 2.03%
  
  
• FlNRA/Bloomberg Active U.S. Corporate Bond Investment Grade Index yields 3.33%
  
  
• Municipal 10-year Bonds yield 2.07%
  
  
• Commodities, due to costs of carrying, have a negative yield
  
  
• S&P 500 dividends provide a yield of 2.04%                   

It is curious that the dividend yield of stocks is very similar to that of U.S. Treasuries and Municipal Bonds.  Please note that the taxation of each of these three categories is very different, so it is not quite an apples to apples comparison.  Still, based upon looking at other investment options, the dividend yield plus the growth potential of the S&P 500 suggests that stocks are more attractive investments over the long-term.

Summary

Obviously, no one can accurately predict with consistency the future performance of investments.  But if you look at overall stock prices objectively, factoring in their valuation, their future earnings potential, their current yield, their collective financial strength, and the alternate investment options, one can make a sound argument for continuing to hold onto stocks and not sell because they are “high”.