The Market is Overheated! Is it time to Sell?

The Dow Industrials reached a milestone earlier this month, passing the 30,000 level. Given the volatility in the market over the last few years and the uncertainty around the COVID-19 Pandemic, people are starting to ask if they should sell all their equity (stocks) holdings and put their cash in something safer, like bonds or just hold it in cash. .

Unfortunately, like most questions in Finance, the answer is that it depends. But the good news is that it doesn’t depend on that many things and in this case, it really only depends on your "investment horizon”. We've also written a blog on this concept here. Simply stated it is the time you have before you will likely need your money. For someone in their 20’s who is saving for retirement (and not saving for a car that they want to buy in a couple of years), the investment horizon is likely decades. But someone in their 60’s who is looking to retire soon, that investment horizon shrinks dramatically and is usually measured in years.

One more thing before I get to the question, we have to talk about the context of the question. One of the other things we talk about is the need to have a balanced portfolio that makes sense given your investment horizon. In other words, when you have a long investment horizon, you typically have riskier assets (stocks of small companies) and with a shorter investment horizon, you move to safer assets (cash or high quality bonds). But you always have a portfolio of different assets – some riskier with higher potential returns and some safer with lower potential returns. As your investment horizon declines, you shift from riskier to safer (sacrificing potential returns for less risk). So, for example, in your 20’s you might have more than 50% of your assets in stocks (equities) – maybe almost everything depending on which advisor you follow. But in your 70’s, that percentage goes well under 50% and approaches zero as you get older, for the reasons we are about to discuss. When you hear about asset allocation, this is what people are talking about.

So no matter your investment horizon, we are assuming that you have some balance of lower risk and higher risk assets. Therefore, the question we really should be asking is whether you should reduce your position in equities – sell some of your stock if you are worried that the markets are overheated.

Now with the caveats out of the way, let’s look at the question again. At the heart of the question is whether the market is going to crash hard since it has run up so fast and if you should reduce your exposure by selling some equities.

As with most questions about investing, it is helpful to look at the past to give us some idea (but not a full idea) of what will happen in the future.

Given we are coming up on the new year as I write this, I thought it would be instructive to see what would happen, depending on your investment horizon, if you placed your money in equities versus Bonds (or another fixed income security). For equities, I used the Dow as I was able to go back 50 years pretty easily to the start of 1971. For bonds, I used 1 year, 5 year and 10 year Treasury Notes as the yields (interest rate) are published. One year treasury notes mature in one year (obviously) and pay out the amount of interest shown. We can compare that to the return in the stock market to see what would have been a better investment. Treasury notes usually don’t come with 20 year terms so I also looked at 30 year Treasury Notes. But it didn’t make a difference in the results as the rates were very similar (for all terms actually).

The chart shows the “winner”, based on your investment horizon, if you would have invested in stocks or bonds on January 1 for each of the last 5 decades (1971, 1981….). So, for an investment made in 1971 for one year, the stock market would have returned 6.1% (not including fees) while a one year bond would have returned 4.9% - a win for stocks. But you can see that with a 5 or 10 year horizon, you would have actually done better with bonds. For 5 years, the stock market returned .3% - almost nothing while bonds reliably returned 6.0%. Similar results for 10 years. However, when looking over 20 years, stocks are the champion again and that is true for every period and that is the main learning from this analysis. When looking over the longest term (20 years or more) stocks will always do better than fixed income securities (bonds). That has been consistently true for more than one hundred years.

So what does that mean for you? If you are a young investor, with a long investment horizon, staying heavily invested in equities as always a good idea as it is very hard to predict where the market is going (even if you are a professional). This “overheated” market may simply the start of a 10 year bull market, as has happened before (for example, in the roaring 1920’s – might there be another one this century?).

But let’s look at the investor with a 5 year or 10 year investment horizon. Looking back at history, bonds beat stocks in 3 of the last 5 decades, making a decision on what to do a lot more difficult. And for the one year investor, it the situation is similar in that stocks beat bonds by 3 to 2 in the last 5 decades.

The reason a decision is more difficult is the volatility of the stock market over shorter periods. While the stock market has reliably produced returns in the 7-8% range over the very long term over shorter periods, the returns can go up and down wildly (as we have seen recently). This is best illustrated by the following chart that shows the return of the Dow over time. As you can see, there are a lot of years where it is red (losses) and many of us can remember the crashes in the early 2000’s and 2008.

Getting back to the original question, why you certainly don’t want to sell ALL of your equities, if you really feel that the markets are overheated it won’t hurt to most some of your equities into other investment instruments. Otherwise, you’ll beat yourself up later.