By Sam Evans, Co-Founder and Lead Coach
The equity market during August historically experiences the “summer doldrums.” Widely regarded as a time to have little expectations of significant market activity, the month of August itself is usually seen as the quiet time of the stock market calendar. This year with COVID-19 and its global economic repercussions, we have seen anything but a slow market. Both the S&P 500 and the NASDAQ have seen powerful market rallies to brand new highs. The Dow Jones Industrial Average is not trailing far behind.
At first glance and looking at the market as it is right now, it seems like the perfect time to be in the markets. Experts on Wall Street are saying that there has never been a better time to invest. Now let me be clear, this is not yet another article telling you that the world is about to fall apart, and we are about to see the next major financial crisis.
As far as probability stands, I will let others call the top of the markets before me. While everyone is trying to be the hero and predicting when the next sell-off will happen, the smart money has been enjoying the ride to the upside the whole time. Those who sat tight during the considerable selling pressure we saw in Q1 of this year have been rewarded for holding their nerves and seen huge rallies back to new highs in many major assets.
However, while I am yet to see any significant signs that an impending market collapse is right around the corner, I am also aware that nothing lasts forever. The longer-term economic impact of COVID-19 is yet to be fully understood. The tech sectors have seen huge gains from the need to work from home, but there is much of this story still untold. I remain “cautiously optimistic” for now, but I am also taking nothing for granted. Assumption is just as dangerous as ignorance and arrogance when it comes to trading and investing. “Protect your profits and manage your exposure” is always the message I relay to my students.
So how do we take advantage of equity markets right now? No matter who I talk to or what I read, I see new and experienced investors piling into the markets, trying to grab their piece of the action as the stock market pushes higher and higher. With the likes of Robinhood now offering “Fractional Shares” to their clients, it seems like even the biggest companies in the world are available to purchase to those with smaller or larger accounts. This, combined with the recent stock splits on Apple (AAPL) and Tesla (TSLA), has made the deal even sweeter for most, at least at first glance. Yet when we dig a little deeper, is it as attractive as it seems?
Look at the chart below of the S&P 500 Index. This is a chart of the last 25 years and is quite an impressive picture, to say the least:
Here at StockAbility, we like to use the S&P 500 as our go-to representation of “The Market”. The index provides us with the best indication of overall stock market health or weakness, essentially because it represents the largest 500 companies from the NASADQ and NYSE, based upon market capitalization. No matter which individual stocks we may be invested in, knowing the outlook and picture of the S&P will always offer us an advantage in general.
However, the above picture can also be deceiving and does not tell us the full story of the stock market and the true implications of its continued rise. Most amateur investors have been taught repeatedly by market strategists and advisors that the market always goes up in the long term and that investors need to adopt the “Buy and Hold” methodology. There have been impressive gains on the broad markets over the last few decades, even with major downturns like the Financial Crisis of 2008. The market does always go up in the longer term, but that is not the issue. Buy and Hold does produce gains… but does it produce the gains you need?
It is a case of simple mathematics, which shows us the lower you buy something, the higher its potential return. On the flip side, the higher the price you pay for something, the lower the possible return rate is. For example, if I buy a stock for $10 per share, it only needs to rally to $20 per share to see a 100% rate of return. If I buy the same stock a year later, when its price is now $50 per share, I would need to see it move to $100 per share to see another 100% rate of return on my investment. Yet, at the same time, my exposure and risk have also increased. Now I have to pay more for the shares to participate. I originally had a $10 cost and exposure, which then increased to a $50 cost exposure for the same gain.
What impacts this even further is the dilemma of when stock prices continue to rise and require more capital to buy, their actual rate of return begins to decrease inversely. Look at the same chart of the S&P 500 over the last 40 years, and you will see my point:
From 1980 to the market top around 2000, the market saw an incredible rate of return of around 1400%. Is this evidence enough that simple buy and hold strategies are all it takes to build wealth over time? If we track the market’s performance since the highs of 2007 to the present day, we see a very different story. A 127% rate of return over 13 years, with some considerable pullbacks along the way. While the market is making new highs, the facts are simple: the higher the prices of stocks go, the lower the rate of return becomes.
The conclusion of this study provides an eye-opening dynamic, which is often ignored, but mostly not even understood by most investors. As the prices of assets go up, our buying power diminishes, meaning we need more capital to buy less stock, therefore increasing our risk and decreasing our return at the same time. Buying a share in the S&P would have cost you around $150 some 40 years ago. Today the same share would cost you $3500. This is the true “cost” of a rising stock market.
Thankfully, there are ways to overcome this conundrum. Vehicles such as Forex, Futures and Options all allow the educated investor to participate in the market for a lower cost and larger potential return. The key is to understand how to use them safely and with low risk exposure, a subject to be explored in future articles. In the meantime, if you found this useful and would like to know more of how to turn this to your advantage, simply register for one of our complimentary StartUp Sessions on our website. I hope you found this helpful.
Be well and take care,