Should I Invest My Cash Even Though Markets Seem Expensive?

Almost daily we hear about how the S&P 500 and other major indices are breaking new highs. In the past 12 months alone, the TSX is up 23%, while the S&P 500 has risen 28%. For those investors who have been fully invested, it has been a great period – not to mention the prior decade. However, for investors who have recently come into additional liquidity or who have been sitting on the sidelines, we are often asked whether now is the time to get into the markets or whether it would be better to wait for a sell-off?

As is often the case, the answer is… it depends. Among broader considerations around risk appetite, goals and overall portfolio construction, one major issue for investors to think about when deploying cash is the time horizon of their intended investment.

Take a look at the past 30 years of the S&P 500 index to illustrate this point (Figure 1 below). Over the past 30 years, the S&P 500 has risen approximately twelvefold resulting in a healthy 8.4% return per annum over this time frame (if we include dividends, this climbs further to 10.7% per annum).

Figure 1: 30 year history of the S&P 500 (1991-2021)

However, if we look at valuation multiples over this same time frame (for example, the Price/Earnings ratio in Figure 2 below), we can see the current dilemma facing many investors sitting with large cash balances.

The P/E as at the end of September sat at approximately 23.1x – well above the average over the past 30 years of 19.6x. With the current P/E nearly 20% % higher than the long-run average, it is easy to understand how some investors may be concerned about a material decline in markets as valuation multiples reset closer to more ‘normalized’ levels.

Figure 2: 30 year history of the P/E ratio for the S&P 500

This is where the discussion of time horizon comes into it. While it is true that the market has benefited from rising valuations, investors who had held the S&P 500 over the past 30 years would have found that the change in valuation multiple over the past 30 years only delivered 0.5% of the 8.4% annualized performance (rising from 19.7x in 1991 to 23.1x as at September 2021).

Instead, the major contributor to the performance of the S&P 500 came from growth in underlying earnings, which explains the remaining 7.9% (see Figure 3 below). In effect, long term performance is driven more by underlying economic growth and the fundamentals of investee companies while multiples remain relatively stationary over the long-term.

Figure 3: S&P 500 Operating Earnings (1991-2021)

While this may be instructive for any investor with a 30 year horizon, how should investors with shorter time horizons think about allocating capital? Once again here we can turn back to history to give us some guidance – this time by examining data on the S&P 500 going back to 1928.

Below is a table that outlines the maximum, minimum and average investment return for the S&P 500 index based on different investment periods since 1928. For example, investors with a 1 year holding period would have seen a maximum return of 169% (1933) while the worst return was a decline of 71% (unsurprisingly, 1932). By contrast, investors holding for 20 years saw a far more stable return profile with a maximum annual return of 14.5% with a minimum return of -3.6%.

Figure 4: S&P 500 returns for different holding periods excluding dividends (1928-2021)

(Please note: this table is best viewed horizontally on mobile devices.)

Taking a more statistical view, Figure 5 below indicates the standard deviation of outcomes over the past 93 years of the S&P 500. For those not statistically inclined (and we don’t blame you!), the chart below illustrates the expected equity returns with a 68% probability based on historic experience (68% being the probability of one standard deviation).

For example, and based on historic data, investors holding the S&P 500 for one year would have had a 68% probability of getting a return of between -12% and +28%. By contrast, investors with a 10 year holding period had a 68% probability of getting a return of between +1.2% and +11.7%. The point here once again is that as holding periods become longer, the range of potential outcomes becomes narrower as the impact of changes in valuation multiples becomes a less material issue.

Figure 5: Standard deviation of S&P 500 returns excl. dividends across different holding periods (1928-2021)

To be clear, we are not arguing that valuations don’t matter or that investors should race to deploy all excess cash into risky securities overnight. Indeed, we believe valuations are important factors to consider and ultimately business fundamentals are critical drivers of long-term investment success. It is also important to remember that we’re looking at broad market indices and that more concentrated investments such as single stocks or individual sectors are more vulnerable to the impact of heightened valuations.

However, for investors with long-term investment horizons and diversified holdings, the old adage of “time in the market, rather than timing of the market” is worth remembering. You may see some volatility in your portfolio in the short term, but over the very long term, equity portfolios are driven by growth in the underlying companies while the noise created by changes in market multiples, largely washes out. Moreover, the risk of sitting on the sidelines with large cash holdings is even more significant currently due to low yields on cash and rising inflation which erode purchasing power.

Thinking about investment horizon is a core component of our overall investment approach at Northwood. When working with clients to understand their goals, we will use low risk investments (cash and short duration fixed income) to meet shorter-term goals where there is little appetite or ability to absorb capital losses. By contrast, very long-term goals (including capital being managed primarily for future generations) are able to absorb greater investment risk and allow clients to employ higher return asset classes, including illiquid investments like private equity, real estate or infrastructure.