Is it time to call the top of the equity market?

Many of the major global markets reached individual all-time highs during March 2024, including the US, European, UK and Japanese markets. This reflects continuing optimism emanating from the steadying of interest rates in response to the fall in inflation. For many investors, a strong bull run leading to a market high is a warning that a market correction may lie ahead. The market is at an all-time high creating the sense that it is entering uncharted territory; like a staircase perilously reaching ever higher into the clouds, the higher it goes the further it can fall. 

This is an understandable gut instinct, but is there anything in it?

It’s not unusual

Firstly, and perhaps surprisingly, markets spend a lot of their time at market highs. In the last 30 years, the FTSE All World global equity price index has spent 22% of month ends at an all-time market high. The finance press tends to report price indices, which do a good job of representing the size of the current equity market, but do not represent what you will have earned from holding a portfolio of equities, as they underestimate it. Conversely, a total return index includes dividends earned and is commonly used by institutional investors for this reason.

The distinction is significant, over the 30 years to the end of 2023 the FTSE All World total return index returned 8.5% pa compared to 6.1% pa for the FTSE All World price index. 29% of month ends were at an all-time market high for the total return index. Framed this way, being at a market high is even less newsworthy.

Does the data tell us anything?

Firstly we’ve got to make sure we are working with good quality information. We need a stock index that fairly represents the market, and all market indices are not born equal. I’m thinking of two commonly quoted indices in particular. The US Dow Jones Industrial Average and Japanese Nikkei 225. If indices were handymen, these two would be the Chuckle Brothers.

Both these indices assume you have bought 1 share in each stock. This is known as a price-weighted index. On the face of it, this sounds reasonable but share prices vary hugely so the index assumes you are investing much more in the companies whose prices are highest, even if that is because they haven’t issued very many shares. It is beyond me why either has any ongoing role in financial markets at all.  Over the last 12 months, the Nikkei 225 has returned 47% but the more representative market cap-weighted FTSE Japan returned only 22%.

Fortunately, most indices are market capitalisation-weighted, providing an unbiased representation of market returns. Now, a legitimate criticism of market capitalisation indices is that they suffer from the flaw that they overweight to overpriced stocks. This is sad but true; however, it’s the market price that’s wrong, not the index approach. Identifying incorrect market prices is a life’s work in itself and beyond the scope of any index.

Now it’s time to ask the big question..​​​​​​

Does the market level tell us anything about future returns?

In short yes it does. Interestingly, global equity markets do tend to perform worse when they are at market highs.  Over the last 30 years, the average monthly return following the market reaching a high is 0.3% compared to an average of 1.0% when it hasn’t. If you look at periods after a market fall of 10% or more from the previous high, the average monthly return is 1.1%.

Disappointingly, you can’t make money out of knowing this. Even if the past were to be precisely repeated in the future, a strategy that sells at a market high and waits until it drops will cost you money in the long run. The reason is that the returns for all three scenarios are positive, which means you’ll be missing out on average if you’re not invested in the market.

Reassuringly simple

And therein lies a reassuringly simple truth - markets tend to go up. The longer you are invested the better. You might as well get invested as soon as possible. As a long-term investor, you will rarely go wrong with this strategy, even if markets are at an all-time high. 

But what about calling the top of the market? The primary issue is at what point do you plan to re-enter the market? Given the market tends to rise the odds are you will be going back in at a higher price. That is unless you aren’t going back in at all - i.e. when you have reached your investment goals. Now that’s a great time to sell out. Until then you are well placed to remain invested, assuming the downside risk remains appropriate for you.

Bottom line? We should be comfortable remaining invested whilst the equity markets are at all-time highs. After all - markets grow, it’s what they do.