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Stocktake: Catching market tops is ‘painfully tough’

Valuations can be a powerful long-term investment tool, but they’re not good for timing

Valuations can be a powerful long-term investment tool, but they’re not good for timing A bull and a bear statue standing outside the Frankfurt Stock Exchange in Frankfurt, Germany. Deutsche Boerse is in advanced talks to buy NYSE Euronext, operator of the New York Stock Exchange. Illustrates NYSE-ANALYSIS (category f), by Nina Mehta and Nandini Sukumar (c) 2011, Bloomberg News. Moved Thursday, Feb. 10, 2011. (MUST CREDIT: Bloomberg News photo by Hannelore Foerster.)

Proinsias O'Mahony's face
Proinsias O'Mahony
Tue Jun 8 2021 - 00:00

Getting greedy in an expensive bull market isn’t wise, but neither is trying to time the top of the market.

Many strategists are cautioning that the S&P 500 is currently trading on a cyclically adjusted price-earnings (Cape) ratio of 37 – a level only ever exceeded at the height of the dotcom bubble.

You can make a strong case for cashing in your chips, says Schroders’ Duncan Lamont, but the problem is it’s “painfully tough” to identify market tops.

He tested a strategy where you exit stocks when the Cape ratio is 50 per cent above its historical average, buying back in when it fell below that level. Such a strategy would have kept you out of stocks since 2013, bar a few scattered months. It would also have caused investors to sell in mid-2003, more than four years before that bull market peaked, and in 1995 – five years before the dotcom bubble burst.

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On average, investors would have lost out on potential gains of 43 per cent by selling too early.

On the plus side, this strategy would have helped you avoid painful bear markets. However, the losses you avoided were not enough to make up for the gains missed out on.

Valuations can be a powerful long-term investment tool, but they’re not good for timing. Expensive markets can get more expensive.

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