S&P 500: Long-Term Return Cycles Now Favor Better Long-Term Market Returns Ahead

 |  Includes: IVV, IWM, OEF, SPY, VTI
by: StopAlerts

If we look past the wild annual swings in total return for the S&P 500 stocks over an 84 year period from the beginning of 1928 through 2011, that noise disappears and a cyclic pattern of rising and falling returns emerges.

Acknowledging, but looking past, the clear and present economic challenges the world faces today and for the next few years, that cyclic pattern suggests that we may be at a trough and ready for a substantial period of rising returns.

We make this observation about long-term charts at the same time that the short-term data looks like markets are rolling over into a bear. Most of the world stock markets are in a bear and much of the US market is too, except for the largest stocks. (see related charts for the short-term at the end of this article). Meanwhile, we are trying to see beyond the short-term horizon with the charts in Figures 1 and 2.

click to enlarge images

Figure 1:

The S&P 500 in its present form was launched in 1957, but there were precursors that have been used as proxies in longer term studies. We don't know which precursors were used, but understand there to be a general agreement among academics as to what they were. We assume a generally accepted set of data was used by our source: Prof. Aswath Damodaran of the NYU Stern School of Business.

The annual data in the chart is all noise, with huge swings from high to low returns.

As we smooth the data with ever longer geometric averages the noise is washed away. The 3-year average is irregular in appearance, but the 5-year average starts to suggest a possible cyclic pattern. The 7-year average has a strong evidence of a pattern, and the 9-year and 11-year averages show a distinct cyclic pattern.

The peaks were in the late 1950's and around the year 2000. The troughs were in the last half of the 1930's and the early 1970's and in 2009.

The 1930's was the Depression era. The 1970's saw a major recession, and 2009 saw a terrible economy too.

The Obvious Negative Contingencies:

Weak as they are, the US and world economies are on the mend. If the European debt and political union crisis, and the Chinese slowing and bank loan quality problem, and the US fiscal cliff and unfunded entitlements don't put the world in a new long recession (and if Iran and Israel don't go to war over nuclear technology), then the next up cycle may be at hand.

Refractory Period:

Various commentators have pointed out that you cannot do as much damage to an economy as we saw in 2008 and 2009, and just march right back up with investor confidence.

Barry Ritholz used the term "refractory period" as the required recovery time before the emotional and financial scars are healed and/or a new batch of investors with new cash, and without that baggage, is ready to move the markets higher.

He presented a chart that suggested the refractory period could well exceed 10 or even 15 years, with little more than flat performance.

The chart he used showed the last bull leg ending in 2000. We are now more than eleven years into a flat net performance. Maybe the refractory period is almost over.

The German finance minister says at least 2 more years of debt crisis will be upon us. Add that to 11 years and we see 13 years of trouble, maybe with net flat stock markets. Those figures line up reasonably well with our cycle charts that suggest that better days may not lie far ahead.

Another Set of Encouraging Charts:

Figure 2 presents the inflation adjusted total return and standard deviation volatility of the S&P 500 for the decades from 1920 through 2010, and the mid-decade 10-year periods from 1925 through 2005 (with a 7 year stub from 2005 through 2011).

Figure 2:

Looking at decades, there were only two from 1920 with a negative rate of return. We just lived through the second one, and this author remembers living through the first one as a beginning investor.

Looking at 10-year spans beginning mid-decade, there was only one negative period (into the 1970's). This last decade looks like it had no return after inflation, but you can't see the tiny 0.13% positive return at the scale of the chart.

Unless we are about to have an experience unprecedented in the past 84 years, we should expect the next 10-years to be positive, if these charts hold up as a pattern. They show several decades of positive, followed by one decade of negative -- and let's hope more decades of positive upcoming.

There may be some logic that after the final carnage is rendered over debt, that the clean slate will be followed by growth.

An unfortunate fact pointed out by Figure 2 and the annual chart within Figure 1 is that we can depend quite assuredly on volatility, and volatility that is fairly consistently higher than mean return.

Proxies for the S&P 500 include: SPY, IVV and VFINX.

Short-Term Price Charts:

These charts look at the short-term for mega-cap stocks (NYSEARCA:OEF), large-cap stocks and small-cap stocks (NYSEARCA:IWM), and the total US stock market (NYSEARCA:VTI).

Things don't look so good, but are not yet as severe as they were the last time the Greek tragedy was played on stage.

We may be in a 50/50 situation with the possibility of a big salvation move by the ECB or the Fed; of a pro-bailout election result in Greece in June on the one hand; and the possibility of a Greek Euro exit and contagion spreading to Portugal and Spain on the other.

If the bad happens those who exit now or who have exited may be better off, but if the good happens they would be chasing price to resume risk asset positions.

The situation is highly uncertain at this time a far as short-term performance is concerned, but we think the balance of forces is more like 60/40 or better for the situation moderating over the next few weeks.

Traders and momentum investors have to be out by now or very soon. Long-term investors, particularly those with high quality companies with well covered growing dividend streams, do not yet have the signals necessary to get out of the way.

The gold line is the 200-day simple moving average. The red lines are percentage offsets from the trailing one-year high price (dotted line 5% offset, dashed line 10% offset, solid line 15% offset, bold solid line 20% offset). A 10% decline from the high is considered a correction. A 20% decline is considered a bear market. A 5% decline is just normal noise, as may be 10% as well. A 15% decline, we call a severe correction, but is also within the volatility range of most stocks.





Disclosure: QVM has positions in SPY as of the creation date of this article (May 18, 2012).

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