The S&P 500 has had a strong run. The index is up almost 50% over the last two years. After such a strong performance it is natural for investors to wonder what the future holds. Is this performance going to continue or is the market due for a correction?
Like any time the new year comes around, there is no shortage of commentary that seeks to predict the market's performance over the coming year. Most of this commentary focuses on economic factors such as quantitative easing, GDP growth, etc. Needless to say, opinions vary widely.
I seek to provide an alternative perspective.
This article looks at returns following similar bull markets, over a 60-year period.
I am a firm believer that history repeats in financial markets. This fact is easy to forget when an investor is constantly bombarded with quarterly earnings announcements, daily price movements and economic data releases, and reminds me of this quote:
"We learn from history that we do not learn from history"
If history repeats, investors can expect lower-than-average returns over the next two years since returns of this magnitude are typically followed by negative, or below-average, market performance.
Please note that my article relates to the next two years, and does not seek to predict returns for the 2014 year in isolation.
Two-year rolling returns
The chart shows returns on the S&P 500:
I use the rolling two-year return as it exhibits a reasonably consistent pattern over the 61-year period.
The wave like pattern reflects the fact that returns revert to their mean - a phenomenon that is well documented in finance literature.
I rarely invest purely on a quantitative basis. But when I do, I prefer to use robust patterns that have been repeated over decades and stood the test of time. A pattern of this nature is likely to recur, and ultimately useful for investment decisions.
Rolling two-year returns tend to peak at ~40% to 60% and bottom out at ~0% to -20%. The peaks and troughs are a similar distance apart, though there are exceptions (which I discuss later).
Returns above average
As at 31 December 2013, the two-year return was 47.0%. This compares to a mean return of 17.5% for the S&P 500. On a per annum basis, this is 21.2% (compounded) against an average of 8.4%. Put another way, returns are around 2.5x higher than the market average. If they are to revert, then a period of lower returns could be on the cards.
But what can we learn from similar bull markets? Were these periods followed by a correction, or continued momentum?
There were 15 other occasions where the market has performed this well (+40%) in the last 61 years:
High returns followed by low returns
Out of the 15 other times that the market has performed so strongly...
...7/15 times: followed by negative returns over the next two years:
...5/15 times: followed by below-average (but still positive) returns:
...3/15 times: returns stayed above 40% (and even climbed to +80%):
So, there were 15 other times when the S&P 500 generated a +40% rolling two-year return. 12 out of these 15 times were followed by negative or below-average returns.
Therefore, based purely on past patterns, there is an 80% chance that an investment in the S&P 500 today would produce returns below the index's average over the next two years.
What about the outliers?
What about the remaining 3 out of 15 instances where strong returns persisted for the next two years (and even reached +80%)? Why were returns so high in these periods?
These three periods were:
- 1957: Post-war boom
- 1987: The lead up to Black Monday and the 1987 stock market crash
- 2000: Dotcom bubble
In my view, returns in these periods were driven by non-recurring factors that investors should not expect to repeat again. In particular 1987 and 2000 were market bubbles. When the bubble burst, many investors lost a lot of money.
A bubble may form over the next two years, and drive markets to crazy levels. Although a future bubble is always a possibility, I would not count on it. I would certainly be reluctant to bet my money on another bubble.
A word on market recoveries
Running this data also highlighted an interesting observation about market recoveries following big losses. There were three periods where the S&P 500 lost more than 40% in two years. Losing +40% on an index fund sounds like a complete blow out. However, consider this:
After losing 40%, subsequent two-year returns were:
- 1977: ~70%
- 2005: ~50%
- 2011: ~90%
We can learn three lessons from these recoveries:
- The long-term case for equities is strong, as even after extreme events markets tend to bound back
- Investors should be bold and refrain from selling into big declines
- A contrarian strategy can be very profitable
As at December 2013, the two-year rolling return on the S&P 500 was 47.0%. Returns of +40% have only been achieved 15 other times in the last 61 years.
12 of these 15 times were followed by negative, or below-average, performance over the next two years. This is to be expected, as market returns tend to revert to their mean.
In the remaining 3 of 15 instances, performance maintained its momentum. However, strong returns were driven by market bubbles such as the lead up to the 1987 market crash and the dotcom bubble.
Unless an investor is counting on another bubble, they should moderate return expectations over the next two years. Though returns may be positive, they are likely to be below average (and lower than the last two years).
On the brighter side, this analysis does not suggest that returns over 2014 will be weak, as my prediction relates to the next two years in aggregate - not 2014 alone. There are certainly plenty of positive catalysts suggesting the opposite, but these are outside the scope of my article.
Also, investors can outperform the average market return through superior stock selection. Defensive and value stocks are likely to outperform cyclicals, leveraged companies, and companies with a questionable competitive position, in the event of a market downturn.
Sources: Yahoo! Finance and StockCat analysis
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.