Believe it or not, this may be the best pattern possible for the U.S. stock market. History tells us that the market is likely to increase in value over time. If we were to plot the market's value from the time the market first opened to the current day, a chart of those two points would illustrate a return as such:
However, we all know that the market doesn’t provide a consistent return. On individual trading days, the market can either increase or decrease in value, and the range of potential gains or losses is wide. Over extended periods of time, the market’s actual value may be above or below the expected trend line. In fact, the market’s actual historical return may look more like:
Anyone who knows me or reads my blog is likely aware that I am not one to make market predictions. I have no idea whether the market is near a temporary top or is still experiencing an upward trend after hitting the bottom of an S curve in 2008. However, let’s assume the market has reached the top of an S curve and is currently above the trend line that would represent consistent growth (similar to the illustration above).
If that is the case, there are two ways the market could get back in line with the trend line representing consistent long-term growth. The first and most obvious way this could happen is for actual market performance to curve downwards towards the trend line. This would represent a market correction or even crash.
The second, and perhaps less obvious way that actual returns could become aligned with the long-term trend line is for time to allow the trend line to catch up to the actual returns we have experienced since 2008. In this scenario, the market doesn’t slump but remains stable while time enables price-to-earnings ratios, valuations, and the economy a chance to catch up.
Very few investors enjoy or take advantage of a market correction. In fact, most investors lose control of their emotions when the market experiences a drastic downturn, and do exactly the opposite of what they should do: they sell at market lows – hardly a profitable investment strategy. Consequently, if we are to avoid an over-heated market, it is likely better for most investors if the market realigns itself with the long-term growth rate by remaining flat for awhile and allowing the trend line time to catch up.
Allow me to reemphasize that I am not predicting that the market is in fact at a temporary high and above where it should be. I have no idea what the market will do tomorrow, over the next month, or over the next year. That is why I believe investors should have a well diversified portfolio that represents their risk tolerance and that they stick to through thick and thin.
However, let’s look at the other side of the coin and assume the market is still at the bottom of an S curve, below the long-term trend line, and needs to experience further growth in order to catch up. Even in this scenario, an extended period of flat market performance is hardly a bad thing – it would simply make the potential upside needed to get back to market norms all the greater.
It turns out that an extended period of flat market performance may very well be a positive for investors in any environment, regardless of whether the market is currently over or under-valued.