Buying at the top
This month, several indices have reached new highs. The S&P 500 has passed the 4000 mark. The moment to get in.
Everyone likes to buy low, sell high. It sounds simple, but timing is really the only real source of alpha: a better return than the index. So it does not feel good to buy at the top. In part, this is due to regret, as if I had only entered the market sooner. For another part, it is fear, the fear that the stock market will fall again from the top. Precisely these two emotions ensure that the top is an excellent moment to buy in. A rising share market climbs a wall of fear. Emotions such as regret and fear are necessary for the stock market to continue rising. If everyone is euphoric and thinks that the stock market can rise further, a top can be followed by a correction. Corrections are now inevitable, it is the price that has to be paid for the higher return on shares compared to many other investments.
Someone who invests at the top makes a higher long-term return than someone who invests more than 5 percent below the top. The good news is that more than half the time, the stock market is at less than 5 percent of its all-time high. A new top in the stock market means that there are more buyers than sellers, and that is a positive sign. The reason why more returns can be achieved by entering at the top is that a top is usually followed by a new top in the short term. Only when shares have fallen by more than 5 percent from the top is the probability that something has fundamentally deteriorated. At more than 5 percent below the top, the probability of a further correction is greater than at the top itself. Those who, since 1920, have only sat at market highs and sold when the market fell more than 5 percent, and in the meantime invested in government bonds, made more profit than by staying in the stock market.
A disadvantage of interim exits during smaller corrections is that there is a regular bull market correction. This is usually no more than about ten percent. There is a need to blow off some steam, but nothing has fundamentally changed. The risk for those who try to get out at the top and back in at the bottom is that costs are incurred twice and there is a good chance that part of the upward phase will be missed. Larger corrections usually have a fundamental cause that can be traced back to the economy, liquidity, or valuation. Now the economy is growing faster than we have seen in decades, liquidity is more abundant than ever and if there is a bubble at all, we are only halfway there in terms of valuation. There may be a lot of regret and fear, but this is the time to get in.