Flying Off a Cliff

Just about every time the markets hit new highs the financial media dig up a veritable cornucopia of old stories from the last time it happened, change the numbers around a bit, and republish them almost verbatim.

The fear of heights issue is nothing new—each time we get into that airy territory of "new highs" we're told it's time to worry because, of course, what goes up must come down.

This is crazy. And today we have proof.

This is such an easy thing it's almost too easy for most folks to really understand. We're hardwired to use our "natural" experience of the world as the common substrate for the way we think about abstract concepts. Back in the Stone Age days, without exception, everything that went up came down. We call it gravity. If you were to throw yourself off a high mountain, well, you'd come down and go splat. Our ancestors' brains were very well conditioned with fear to cause them to avoid such things.

But gravity doesn't exist in financial markets. That might sound dumb and excruciatingly obvious, but there's no question the gravity issue is part of what scares folks—the higher we go, the more it will hurt when we fall down. Here's how it really works:

1. Stocks are not serially correlated. Which is a fancy way of saying whatever happened to stocks yesterday has no bearing—absolutely none—on what stocks will do today or tomorrow. Or, as commonly stated, "Past performance is no guarantee of future return."
2. If markets tend to go up over time (and if you disagree with this you actually might be better off in the Stone Age)…they will make a lot of new highs. It's not as if these are singular events. We get new highs all the time.
3. Most indexes, such as the Dow, are so poorly constructed it doesn't matter what they're doing anyway. Don't pay any attention to them.

Aside from theoretical explanations, let's put the issue to rest with some hard data. As depicted below, continuing to stay invested in equities once the market sets a record has historically led to above average returns. Since 1926, one, two, and three-year S&P 500 returns after all-time monthly highs were positive over 80% of the time!

This is a staggering result. Not only do markets hold up fine after hitting all-time highs, but it's actually probable that they'll deliver excellent positive returns from there. Simply gravity-defying! When hitting new highs, stocks don't fall off a cliff…they fly off a cliff.