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Summary

  • Some bears believe solar activity points to poor returns on US stocks.
  • Since 1871, returns have been better between solar minima and maxima.
  • While there are plenty of reasons to be bearish right now, sunspots are not among them.

It is not hard to make a bearish case for the outlook for US stocks right now. The S&P 500 is very dear by historical standards, trading on more than 25 times real earnings of the last ten years. The boom in equities is more than five years old, which makes it long in the tooth. Long-term momentum is at the sort of levels where past peaks have occurred. And quantitative easing -- the lifeblood of bullish speculation in recent years -- is set to end within a few months.

Does solar activity also point to tougher times to come on Wall Street? At first blush, this may seem like an odd question. Quirky as it may sound, though, there is little doubt that solar cycles have a significant influence upon many aspects of the world around us, including the weather, agriculture, and quite possibly upon human behavior.

(click to enlarge)

The solar cycle lasts between 9 and 12 years and is measured in terms of the frequency of sunspots. Sunspots are solar explosions, which show up as darker patches on the sun's surface. These giant bursts of energy reach the earth and are associated with changes in climate, atmospheric pressure, magnetic storms and crop yields, to name just a few things. Currently, we are around the peak or "maximum" of the latest cycle.

There is a belief that the solar cycle may also affect investment returns. Supporters of this view claim that stocks are likely to do better between the solar minimum -- the trough of the cycle -- until the solar maximum -- the peak. For this reason, some reckon that the S&P 500 is likely to top out within a few months of the possible current solar maximum. Does history bear this out?

Let us look at the facts. In the 12 solar cycles since 1878, a strategy of buying the S&P 500 at the solar minimum and selling at the maximum would have delivered a median annualized real total return of 10 per cent. By contrast, the annualized return on the S&P 500 over the long run has been 6.7 per cent. Only during 2 of 12 cycles would this approach have delivered negative returns.

(click to enlarge)Real annualised total returns from investing between solar minima and maxima

Real annualized total returns between solar minima and maxima; data from Robert Shiller

On the face of it, this performance looks impressive enough. I have therefore tested a strategy of investing in the S&P only between solar minima and maxima and then switching into cash earning interest at the 3-month Treasury bill rate for the rest of the time. Such an approach would have earned a real total return of 5.7% a year, versus 6.7% for buy-and-hold.

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Of course, such small differences in returns stack up hugely over time. Just looking at the period since 1950, a $1,000 buy-and-hold investment in the S&P would today be worth $91,000 after inflation. The same $1,000 switched between the S&P and interest-bearing cash according to solar activity would have become only $32,160.

Believers in solar-based switching sometimes argue that commodities are the logical alternative to stocks between solar maxima and minima. Low sunspot activity has been associated with lower crop yields, which in turn would likely drive up prices for some agricultural commodities. So how would switching between stocks and commodities have done over the sweep of history?

In my simulation, this strategy would have returned a mere 4 per cent annualized in real terms over time. (For an investment in commodities, I have used an index of wholesale commodity prices for the period 1871-1970 and then the energy-skewed Goldman Sachs Commodity Index thereafter.) This is plainly worse than the effects of switching between the S&P and interest-bearing cash.

Long S&P min to max, then cashLong S&P max to min, then cashBuy & Hold S&PLong S&P min to max, then commodities

Long S&P max to min, then

commodities

Return (%)5.723.366.744.003.74
Volatility (%)7.7912.1814.3212.9113.99

Robert Shiller; Investors Chronicle

Despite its underperformance of buy-and-hold, a solar-based S&P/cash switching strategy would have had one obvious use. While its returns were a percentage point below buy-and-hold, switching ran a great deal less risk. The annualized volatility of buying and holding the S&P was 14.3% between 1871 and 2014. Switching only suffered volatility of 7.8%.

Solar-based investing is plainly not to be recommended as an alternative to buy-and-hold investing. However, the occurrence of a solar minimum, especially at a time when stocks are depressed, might be taken as a supporting reason for going tactically long the S&P. The key question right now is naturally whether the solar maximum is a reason to sell out of the market.

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Real annualized total returns btw solar minima & maxima; data from Robert Shiller

The S&P's performance between solar maxima and minima has not been all that bad. The median annualized return during these periods has been 6.3 per cent, against 11.2 per cent during minima to maxima. It so happens that some of the worst market shakeouts have taken place during these phases, including the Great Depression, the 1960s inflationary malaise and latterly, the credit crunch.

Systematically buying the S&P at solar peaks and switching to cash at troughs -- the opposite of the strategy already discussed -- would have fared badly. With an annualized total return of 3.4% and volatility of 12.1%, it offered a particularly unappetizing reward-to-risk ratio. Using commodities instead of cash boosted the return to 3.7%, but also swelled risk to 14.0%.

Where does this leave investors today? Personally, I do not see solar activity as a reason for selling out of US stocks and switching into cash. Quite aside from the theory behind it, the historical record of selling up at solar maxima is very mixed.

That said, I do see the S&P 500 as being at risk of poor returns over the coming five years or so. This is largely to do with stretched valuations, a likely fall in corporate profit margins, and the impending withdrawal of Quantitative Easing. I have therefore skewed my own holdings away from US large-cap equities in favor of Europe and Japan.

Source: Sunset For The S&P 500?