Should You Invest At The Peak Of The Stock Market?

Here is the simplest explanation why you should.

Before I became a Portfolio Manager 15 years ago, I briefly went into a glamourous field of finance – Mergers & Acquisitions. After my degree in Financial Engineering, I was eager to tackle some complex models and intellectual challenges.

Oh boy, how I was disappointed! The models turned out much simpler than I imagined. 

So much for the fancy maths. But here is the great part. You will understand basic stock market valuation in the next 10 minutes.  

Instead of showing you a chart of how the market performed in the past – which often doesn’t convince the investors I speak to – I will tell you the reason why the market will keep hitting new highs.  

And why you should never be afraid of investing at market peaks. Peaks are not the exception. Markets not being at their peak are. 

KEY TAKEAWAYS

  • There are two key components to the value of the stock market: change in investors’ mood and earnings growth. These two factors explained over 85% of the S&P 500’s total return over the past decade. The third component—dividends—is usually well understood by investors.
  • Investors’ mood matters in the short to medium term. But, even if the markets panic, earnings may save your investment. 
  • What’s the condition? Sitting it out for about 10 years. For example, the S&P 500 went nowhere from 2000 to 2012. The mood hit rock bottom. The euphoria in 2000 was replaced by fear and caution in 2012. Why did the S&P 500 bounce back? Leave them enough time and earnings offset any drop in mood. Over that decade they increased 80%.
  • Earnings don’t necessarily track the broader economy. But, that’s an advantage for you, because listed companies expand internationally and remain very profitable.
  • Should you invest at a peak? Yes, because peaks hide even higher peaks. Since the 1950s, the S&P 500 has been within 5% of an all-time high over half the time. But your emotions play a role too.
Here is the full analysis

Are you or your friend stuck because of one of those questions?

You’re in luck. I will answer them today. You only need to read one simple story about a Japanese Cyclist to understand how the stock market works.

Kumiko goes adventure cycling!

BUT BEFORE, SHE WANTS TO SELL ALL HER STUFF

2023: She Calls Ethan, The M&A Banker.

Kumiko: Hi Ethan, I want to take a sabbatical and cycle the world. Now, as you know I run this company that produces Golden Retriever Snacks. Can you sell it for me? How do you come up with a price?

Ethan: Sure, I will tell you a secret. Look, we have fancy cars and nice suits here, but our models to value companies are archaic. How much is your company making?

Kumiko: It makes €1 Million in Profits per year.

Ethan: Well done. Listen, valuing a company is quite simple. We basically look at what similar companies sold for in the past 12 months. On average, they sold at 10x profits. Congrats – You’re worth €10 Million!

Kumiko: Can this 10x multiplier change over time? 🤔

Ethan: Yes, it can. It depends on the company’s prospect but also on the mood or sentiment of the buyers and sellers. 🤑😨

Kumiko: OK, sell it now. Can’t wait to hit the road. See you next year, Ethan!  🚴‍♀️🌍

2024: Kumiko wants her company back.

Kumiko: Hi Ethan, I just came back from my trip. Time of my life. Now, I will start a family, so I may as well take back the company.

Ethan: You’re so lucky! The new owner just called me. He wants to sell. But you know, profits have risen by 7%. last year. It now makes €1.07 Million.

Kumiko: What about the famous multiplier?

Ethan: It’s still 10x. Investors’ sentiment hasn’t changed. You can get your company back for €10.7 Million.  

Kumiko: Amazing. If only buying stocks was as easy!

Ethan: The process is much easier. The valuation? Quite similar. Let me show you.

What if KUMIKO invested in the stock market instead?

The easy way to value a stock market

the panic and greed indicator

Kumiko: I was thinking, maybe it’s easier if I use my capital to invest in Stocks instead? But how do you value them? It seems much more complicated!

Ethan: Wise idea. A lot of entrepreneurs like you turn to safer and more diversified portfolios. I can’t value the S&P 500 for you, but the smartest people all around the world are doing it every second.

Kumiko: Great, but what’s the multiplier?

Ethan: It’s a blend of multipliers for different industries. There is more than Golden Retriever Snacks on the Stock Market! Today, it’s 33x profits. The overall profits per share of the S&P 500 are around 160. 160 x 33 = 5,300, that’s the value of the S&P 500 today!

Kumiko: Wow. But, is the multiplier stable? What if I want to sell tomorrow?

Ethan: Here is the bad news: it’s not. Investors are moody.  They can become greedy and get FOMO, or panic. Let’s look at some of the historical swings of mood below. Now pay attention. There are three black buttons in the animation below

⚠️ 🚨 First, use the arrow navigation ⬅️ ➡️ to see the story in 10 slides! Then press ▶️ for the full animation

investors' mood: Historical swings

Press the arrow below to understand how it works in 10 steps

How much money can I lose?

Kumiko: I get it. So the worst case is just above a 50% drop in the multiplier. So if today it’s 33x, I can expect maybe x16 in some of the worst cases like the dot com crash or GFC? Will I lose half of my money?

Ethan: You got it! It may feel painful in the short term, because earnings can also have a few bad quarters. But in the medium term it’s not quite as bad. Let me show you why.

Why the stock market always goes up

Investing at market peaks is normal!

The Stock Market performs better than The Economy

Kumiko: But what if the multiplier drops to 16x and stays there? What if investors become gloomy a catch the permabear disease? 🐻

Ethan: Well, here is the beauty of long-term investing. The multiplier only plays a role in the short to medium term. But invest over a decade or more and it matters less.

Kumiko: But why? 🤔

Ethan: Because the economy will grow again. Earnings too. The earnings’ recessions are relatively short. Over the past two decades, the GDP grew by 4.4% on average in the US. The S&P 500 grew almost twice as fast at 7.6%. Guess where most of it came from? Earnings. They grew by 7%!

Kumiko: That’s odd. Seems like a bubble. 🫧 Why would the Stock Market grow faster than the GDP? Isn’t the stock market supposed to track the economy?

Ethan: Not really, no. Look at the S&P 500. It’s usually concentrated. Today, almost a third of it is just in 7 companies. Also, U.S. companies generate 40% of revenues from abroad! They are some of the best companies worldwide. They hire the brightest people – look who’s leading Apple, Tesla or Microsoft. They figure out how to be positioned in the best markets globally. They are also paid bonuses in stock options. These people are very incentivised to make their companies much more profitable than the average U.S. company. Profit margins have increased from 3% in 1990 to 12.5% in 2022! And bankers like me help them with tax and financial engineering to make it even juicier. 📈

Waiting for a crash can take a long time. The S&P 500 is within 5% of an all-time high just over half the time!

Kumiko: So, if investors weren’t moody at all the multiplier would reflect a decade-long outlook. It would be stable? Then, every year you’d have to invest at the market peak! Because each year – in an ideal world – earnings would just go up. Slowly but consistently. So, statistically, it makes no sense to wait to invest?

Ethan: Exactly. Investing at market peaks is normal. If earnings were smooth and everyone was a long-term optimistic investor without short term mood swings we’d be investing at market peak every year! That’s the key reason why since the 1950s, the S&P 500 has been within 5% of an all-time high just over half the time! ⚠️

What if investors stay gloomy for a decade?

You still won't lose money!

Kumiko: I should maybe ride along. But, what if I get the timing wrong? What if the multiplier drops by 50% 📉 when I want to cash out? Will I still recover my money?

Ethan: Yes. As long as you stayed long enough. You can never time the market mood, but earnings’ growth compounds. Over the past few decades, the S&P 500 earnings grew on average by 7%. At this rate even if the multiplier dropped by 50%, a 7% annual earnings growth increases earnings by 100% over a decade. It would offset the 50% drop in the multiplier!

Kumiko: Give me a real-life example.

Ethan: Take the 2000s lost decade. It’s been really bad. A few of my banker friends haven’t looked at equities since then. A real trauma. We had a rare case of two crises just a few years apart: dot com in 2001 and GFC in 2007. In August 2000, the S&P 500 peaked at 1485. It bounced back to this level only a decade later – In December 2012! On the surface, nothing happened. In reality, the multiplier dropped 📉 – confidence was much lower a decade later – but earnings went up 80% 📈. As a side note – in real terms, the recovery took a couple of years longer.

Earnings are All that matters in the long run

Kumiko: And now we have an amazing decade… Can you show me how the earnings evolved over time?

Ethan: Sure. Look below. I ran two analyses for you. Click on the first tab 📑1️⃣for the higher frequency data from 1988. Click on the Second tab 📑2️⃣ to go back over a century! In reality, earnings and sentiment are quite correlated, that’s why the markets are bumpy in the short term! But next time someone tells you Stocks are hopes or dreams? Maybe in the short term, but if you’re a serious long-term investor all that matters are the earnings!

Next time someone tells you the stock market is a casino 👇

Should I invest in the S&P 500 then?

You can't go wrong

But Take Into Account Your Circumstances

Now, you may ask – should you invest in one go?

Most entrepreneurs like Kumiko who get a large sum and invest for the first time usually spread it out over several quarters. That’s because while numbers are on their side, emotions not always are. The sums are usually life-changing and they want to minimise regret, especially after such a long bull market. But if they want to stay too long on the sidelines, something is off with their asset allocation. Maybe the portfolio is not robust enough for their risk tolerance?

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And do consider a Global ETF!

As a broad market index comprising 500 of the largest publicly traded companies in the United States, the S&P 500 provides diversification across various sectors.

Over the last century, the S&P 500 has delivered strong returns, averaging about 10% annually (earnings growth and the multiplier are not the only components – there are dividends too).

Some investors – including us – think that you should think even bigger and maybe invest in a  Golden Retriever Portfolio🐶. One reason is that one country is always more vulnerable than Global Markets, so the recovery may take longer.

👉 Read how Global ETFs compare with the S&P 500

But remember –  Peaks are not the exception. Markets not being at their peak are. 


Epilogue 🤓

In reality – as some Bankers may tell you – M&A and Equity Markets can get more complicated. For example, back in the days, when I was a junior banker in M&A I quite enjoyed real options pricing for Biotech companies. But EBIT(DA) multiples and DCFs are irrelevant to the goals of most individual investors. Can’t blame them!🤷 As for me, 15 years ago I went into Asset Management doing some really cool stuff. But that’s a story for another guide.👋

Thank you for reading.
Good Luck and Keep’em* Rolling!

(* Wheels & Dividends)

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