Four years ago, March 6, 2009, the Dow Jones Industrial Average Index for stocks hit its most recent low of 6,443.27, having lost over 54% of its value since the October 9, 2007 high of 14,164.53. Yesterday, March 5, 2013, the Dow closed at a new record high of 14,253.77. But what does it mean for your investments and the stock market?
'Animal Spirits' and the 'Rhyme' of Stock Market History
No one knows what the future holds but if history is any indication, a new record high on the Dow is no indication that stock prices will continue moving higher at a healthy pace, nor does it mean a temporary "high" has been put in and thus the market retreats to the downside from there.
From a historical perspective, stock prices typically jump 70% within the first year or two after reaching a bear market low. And when declines are more severe, such as the 2007 to 2009 decline and that of The Great Depression, a larger bounce of 100% or more off of a bottom can be considered "normal" or expected. But what pushes prices from here?
As one of the most highly respected economists of the past century, John Maynard Keynes, noted... "a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic." Keynes referred to this positive push from human nature, "animal spirits." In translation, stock prices can rise for sustained periods of time simply because of positive momentum and consumer confidence.
This where fundamental analysis yields to technical analysis: Stock prices can rise beyond the level at which they may be considered "fairly priced" by a fundamentalist (think Warren Buffett) and reach irrational levels (think momentum investing and the "dot com bubble" of the late 1990's).
As Mark Twain famously quipped, "History does not repeat itself but it does rhyme." History and logic do have some correlation with each other in hindsight. It is likely that stock prices are now reaching highs that a rational investor may consider unsustainable. But the investor herd does not always act rationally.
History and the Victory of the Long-term Investor
Long-term investors need not worry or get too excited about the new record high on the Dow. However, they may congratulate themselves for holding onto stocks through the panic of 2008, where stock prices fell 18% in the first week of October 2008. From the bottom of March 2009, it took 4 years to recover your "loss" (or what I would call a "decline in value" because you do not lose or gain anything until you sell). From this historical perspective, you may reasonably expect that, if you have at least 5 years to invest, stocks can be a suitable investment. However, you may use a 10-year period for more aggressive mutual fund portfolios (higher risk tolerance).
The long-term view is: If the market continues higher, great. If the market falls, I can continue dollar-cost averaging and continue building my portfolio and reap the benefits of higher prices 4 or 5 years down the road.