We believe that capital markets can be viewed as seasons. Just as fall differs from spring, investment climates vary too. When stock prices are strong, as they have been since 2009, almost all equity investments do well – but such situations are not the norm. Historically there have been long periods where stocks go down or tread water. For example, the NASDAQ Composite Index climbed to 5,000 in 2015, its highest peak in 15 years.
Financial markets go from periods of being overvalued to undervalued. These are certainly easy to see in hindsight but they can be identified in real time. An undervalued stock market puts the wind at your back, and depending on your time horizon and risk appetite, it can deliver above average returns. Conversely, overvalued markets create headwinds that many traditional buy and hold strategies do not address.
However, when stocks do poorly, it is quite possible that other investment classes will do well. This is at the heart of the theory of diversified asset allocation – some investments zig when others zag. There is no guarantee, though, that these relationships will hold up during severe market stress. Even the most bedrock diversification, that of stocks vs. bonds, has shown to be quite variable. Understanding the changing relationships between different asset classes is critical to success.
Using history to inform your investments is not market timing – it’s just sensible.