This has been a phenomenal year for the stock market. As of this writing, the S&P 500(SNPINDEX: ^GSPC) has crested the 6,000 benchmark and continues to head higher.
There’s a lot of excitement around the stock market’s performance over the past two years, but many investors may be worried about the potential for a pullback or correction. Some may be hesitant to buy at what could be the peak of the market, and those with much of their money invested in stocks may feel we’re closer to the end of the bull market than the beginning. We could be watching a full market cycle play out in fast forward.
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But history has a clear answer about investing in stocks when they hit a new all-time high. And although the past is no guarantee of future results, we can use it to help guide our investment decisions.
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One of the core tenets of stock investing is that, over the long run, stocks as a group increase in value. Given that fact, it’s natural for the S&P 500 to trade at all-time highs. In fact, the market usually goes on to reach many new all-time highs in quick succession.
We saw that play out in 2024. Through Dec. 6 this year, the S&P 500 has notched 57 new record closes. And that’s not even close to the highest number ever. There have been four years since World War II during which the S&P 500 hit more than 60 record closes. The stock market closed at a record high 77 times in 1995.
In fact, 2024 looks somewhat similar to 1995. That was the year that Alan Greenspan, then the Federal Reserve chairman, successfully navigated a soft landing, preempting potential inflation as unemployment fell without putting the economy into a recession.
Jerome Powell, the current Fed chairman, is trying to pull off a similar feat, curbing high inflation without affecting low unemployment rates. So far, he’s been successful. The Fed’s first rate cut came in September this year, and the economy has thus far responded well.
Investing in 1995 may have been equally as daunting as it is today. Stock prices and valuations zoomed that year. On top of that, a technological revolution (personal computing and the internet) was just starting to take hold, and even though there was a lot of optimism about it, there was still uncertainty about how it would affect the world.
If you invested in an S&P 500 index fund at the end of 1995, your investment would have gone on to increase 155% over the next four years, growing at a rate of more than 26% per year. The dot-com bubble popped in 2000, though, and the market went on to crash more than 45% from the start of 2000 to October of 2002. That said, the investment made at the end of 1995 was still up 40% at the bottom of the dot-com crash.
Again, there’s no guarantee that the late 2020s will look anything like the late 1990s. But history suggests that the market can keep going up for a very long time even after strong price performance and new all-time highs. Investing at an all-time high — any all-time high — is usually a good strategy.
You might be surprised to learn that the S&P 500 performs exceptionally well, on average, in the period immediately following the day it reaches a new all-time high.
Between 1970 and 2020, the S&P 500 produced an average five-year cumulative return of 78.9% if you bought on days it closed at a new all-time high. By comparison, investing on any random day produced an average five-year return of just 71.4%. The pattern holds for shorter periods as well.
You might think you should just wait for a down day. But investing on days when the market closed below its all-time high resulted in worse returns over one- and two-year periods since 1970 compared to investing at the all-time high, according to data from J.P. Morgan.
It’s worth putting the historical returns in the context of 2024. Since hitting a new all-time high for the first time in over a year on Jan. 19, the S&P 500 has increased more than 25%. That’s far above the average returns for investing at an all-time high. But it’s important to realize the first in a succession of all-time highs will have returns that are well above average.
The performance we’ve seen in 2024 isn’t an aberration by any means, and a continuation into 2025 wouldn’t be unprecedented. Still, investors should understand that good times won’t continue forever, and it’s important to maintain reasonable expectations.
It might become a lot harder to find great individual stocks to buy when the S&P 500 is trading at or near its all-time high. Patient investors could do well if they are willing to learn about lots of companies, identifying trends, following macroeconomic factors that could affect certain industries, and valuing individual stocks. Finding a great company with a stock trading at a fair price is a great recipe for long-term investing success.
But for those who don’t want to spend all of their free time researching individual stocks in the hopes of outperforming the S&P 500, index funds can offer a great alternative. An S&P 500 index exchange-traded fund (ETF) like the Vanguard S&P 500 ETF(NYSEMKT: VOO) offers an excellent way to ensure your investment keeps up with the benchmark index.
The ETF’s expense ratio of 0.03% means you’ll pay only a few pennies for every $100 you invest in the fund. On top of that, Vanguard boasts a low tracking error, which ensures the value of the fund never strays too far from the index value.
The current composition of the S&P 500 suggests there may be more opportunities with smaller companies. In fact, the S&P 500 hasn’t seen this much concentration among the top 10 constituents since before 1970. Investors who want greater diversification than what is offered by the Vanguard S&P 500 ETF have several options.
One is the Invesco S&P 500 Equal Weight ETF(NYSEMKT: RSP). Instead of weighing each component of the S&P 500 by market capitalization, the equal-weight index fund, as the name implies, weighs each stock equally, rebalancing once per quarter. Historically, the equal-weight index fund outperforms the market-cap-weighted index over the long run, although that hasn’t been the case over the last decade.
Another option is the Vanguard Extended Market ETF(NYSEMKT: VXF), which tracks every U.S. stock except those in the S&P 500. This ETF can be a great all-in-one solution to gain exposure to mid- and small-cap stocks with its low expense ratio.
Investors may also consider funds that track a more specific segment of the market like small-cap value stocks, which appear well positioned to outperform in the current market after years of lagging the large-cap index. While the only way you can outperform the S&P 500 is by investing in stocks outside of the index, it’s important to remember it comes with the risk of underperforming the index as well. There’s no telling how long the current trend of large-cap outperformance will continue, even if you’re using history as a helpful guide.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
