Throughout 2017, the S&P 500 Index recorded 62 new closing highs in 251 days of trading. In the first three weeks of January 2018 alone, the index crossed 10 new record closing highs in 13 days of trading.
With stock indices continuing to set new highs, does this mean negative returns for stocks are on the horizon? When addressing this question, it is helpful to keep the following in mind:
- Every day, stocks have a positive expected return regardless of whether markets are at an all-time high or not.
- While expected returns are always positive, positive realized returns are never guaranteed and may deviate from expectations.
The reason we can expect positive returns, regardless of the current market level, is attributable to the mechanism by which markets set prices. Stock prices are the result of the interaction of many willing buyers and sellers. Current prices reflect the discounted value of future cash flows expected by those buyers and sellers. But, there is uncertainty around these future cash flows for stocks, and investors bear the risk of potential losses. If the buyer of a stock views the future cash flows as more uncertain, they will likely want to pay a lower price for the stock. They will only transact when the price reaches a level where they expect to earn a positive return. For these reasons, we expect stock market prices to be set to a level at which the required rate of return for investing in stocks is positive, whether the market is at a new high, a new low, or something in between. Otherwise, why would buyers in the marketplace willingly transact at a given price?
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