After a small decline in October, the market has clearly regained its stride. Large-cap stocks in the U.S. have rallied 5.7% in November and are up over 27% this year⁽¹⁾. Relative to the typical annual stock market gain of about 10%, the year-to-date return in 2024 has been significant. Investors have much to be thankful for as we approach the Thanksgiving holiday.

Last week’s Market Update highlighted the fact that investors would be wise to temper their expectations as we look forward. Our focus was centered on valuation, which is one of the best predictors of long-term returns. At a basic level, the higher the price you must pay relative to business fundamentals, the lower the future returns have been over time historically. As we stand today, valuations for the large-cap stocks of the S&P 500 have only been higher 3% of the time since the turn of the century. This would suggest that below-average returns moving forward represent a good bet.

A common reaction among investors to either A) falling stock prices or B) an expectation or fear that stock prices might fall in the future is the desire to sell stocks and move to cash. This strategy, which is clearly aimed at avoiding a big decline in portfolio value, also comes with considerable risk.

The chart below helps illustrate this risk and demonstrates why liquidating stocks and moving to cash is likely to be a mistake. It shows the average return difference between stocks and cash measured across various timeframes.

Source: MorningStar Direct. Data from January 1926 through October 2024. Returns are based on rolling monthly periods. Stocks are represented by the IA SBBI Large Cap TR Index. Cash is represented by the IA SBBI 1-month Treasury Bill Index. Returns are cumulative.

With data going back to the 1920s, the chart incorporates a tremendous amount of history. It includes other periods of high valuation, such as the Roaring 20s, the Nifty-Fifty bubble of the late 1960s, and the Technology bubble of the late 1990s. It also includes the Great Depression, World War II, the stagflation of the 1970s, the bursting of the aforementioned stock bubbles, the Financial Crisis in 2007/08, a pandemic, and an endless list of other bumps along the way. Despite all of this, the average 12-month period saw cash underperform stocks by -9%! This represents a very steep opportunity cost incurred when moving from stocks to cash, and it only grows larger as the measurement window is expanded. Sit out for three years, and an investor could miss out on an excess return of 30%. That increases to 157% over 10 years, and a breathtaking 2120% over a 30-year period. The penalty for not staying invested has been severe on average. 

Despite the lofty valuations we see in certain areas of the market, there are reasons investors should be comfortable holding on to their stocks.

1. While valuations are one of the best indicators of long-term returns, they are not a useful tool for market timing in the near term. High valuations can move higher, and they can remain there for extended periods of time.
2. A price decline is not the only way for the market to correct elevated valuations. Improving business fundamentals, including accelerating earnings growth, can also serve to lower common valuation metrics, such as the price-to-earnings ratio.
3. Other areas of the stock market are not nearly as expensively priced as the large-cap U.S. stocks. Small and mid-caps, value, developed international, and emerging market stocks all have considerably lower valuations.

While holding cash rather than stocks during an extended market decline would add value, it is notoriously hard to predict when those declines will begin and how long they will last. On average, there is a cost to sitting on the sidelines. As we have seen, it starts pretty high for short periods and becomes astronomically high over longer periods. Investors would be best served by avoiding that cost altogether and sticking with their diversified portfolio. 

1. Large-Cap U.S. stocks are represented by the S&P 500 TR Index. Return as of 11/26/2024.

Source: MarketWatch

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