2021's Risk-Adjusted Returns In Context, And Outlook For 2022
- The past year saw both well above average total and risk-adjusted returns as equities rallied and volatility receded from the prior year.
- This article puts 2021's returns into a historical context and tries to glean takeaways for returns in 2022.
- Higher short-term rates, a very likely outcome in 2022, have tended to be correlated with below trend equity returns.
- Rising volatility has also tended to be correlated with lower equity returns, and rising volatility after 2021's below average print feels like a more likely outcome than receding volatility.
- Very attractive absolute and risk-adjusted returns - like we saw in 2021 - do not tend to be replicated the next year.
I have been away from contributing for a few months. Family obligations, my busy day job in investment management, the launch of a new investment endeavor, and the general strain of an extended pandemic made me re-focus my time commitments. While I did not expect to be sidelined so long, I do expect to author more in 2022 albeit likely in less frequency than my previous publishing. As 2021 comes to an end, I found myself updating a dataset that I have used for articles in years past. At year-ends, I like to put the year's previous returns into a historical context based on risk-adjusted returns. In past versions of this article (year-ends 2020, 2019, 2018), I have found that framing the past returns has had interesting insights into the coming year.
The S&P 500 (NYSEARCA:SPY) total return for 2021 at 28.7% (including reinvested dividends) was above well above its long-run average of nearly 11%. When adjusting for below average volatility, the risk-adjusted return was the 13th best in the 88-year data set. Absolute returns were high, and risk-adjusted returns when taking into account receding volatility, were even higher.
When we review 2021's performance, this article seeks to answer a couple of forward-looking questions:
- Given the rally that the broad market staged in 2021, how strong were 2021's risk-adjusted returns in an historical context?
- What has happened to market returns in subsequent periods after risk-adjusted returns of similar magnitude?
To answer these questions, I sought to calculate Sharpe Ratios for the S&P 500 (SPY) and its predecessor indices for as long of a dataset as I could find. Developed by Nobel Laureate, William F. Sharpe, a Sharpe Ratio is a measure of risk-adjusted returns that takes the excess return of an asset over risk-free rates divided by a measure of volatility.
In my dataset, I used the annual returns of the S&P 500 and its predecessor indices taken from Bloomberg, and then subtracted the average 3-month Treasury yield taken from monthly data from the Federal Reserve Bank of St. Louis, and divided by my volatility measure. For volatility, I used the standard deviation of day-to-day logarithmic historical price changes over the previous 260 trading days, a period approximating one year. (For Bloomberg users, this is the field Volatility_260d).
Source: Bloomberg, S&P, St. Louis Fed, Ploutos
In 2021, the absolute total return of 28.7% ranked 18th in our 88 annual observations, but 13th on a risk-adjusted basis given the below average volatility we experienced over the course of the year. Ok, Ploutos - we know 2021's bumper crop of returns were great, but are there any insights to be gleaned from this dataset moving forward?
The Impact of Rising Short Term Interest Rates
Thinking about this calculation again one year forward at the end of 2022, it would be very surprising if short-term rates were not higher. After all, the 3-month Treasury bill yield averaged only 0.05% in 2021. Most market participants expect the Federal Reserve to lift short-term interest rates in the coming year. Futures on the Federal Funds Rate are pricing in nearly three 25bp hikes over the next year. Are rising short-term interest rates - our base case expectation - good or bad for stock returns? We know that rising short-term rates tend to happen in a positive economic environment as the Fed moves to cool mounting inflationary pressures. Conversely, big reductions in short-term interest rates - think 2008, 2001, and the early days of the pandemic response in 2020 - tend to come with unraveling economic conditions.
To answer this question, I split the list into two parts - years where short-term interest rates rose and years where short-term interest rates fell. I then calculated the geometric mean of the annual returns under each interest rate outcome.
Returns are meaningfully higher when short-term interest rates are falling. Perhaps, this is not surprising, lower short-term interest rates support the economy, and are the primary monetary policy tool. For me, 2008 (-342bp change in average 3mo Treasury yield and -36.6% S&P 500 return) and 2001 (-243bp and -11.9%) - years when sharply lower short-term interest rates were indicative of dramatically worsening economic and market conditions - stick out as countervailing examples. Even including these years of sharply lower front-end rates with very negative stock returns, stocks tend to do much better when short-term interest rates are moving lower. That is unlikely to be the case in 2022 in the United States.
The Impact of Volatility
It is far less surprising that when volatility is higher, equity returns are lower. While 2020 may stick out as an example of a year when volatility was high and returns were high, it was certainly the exception and not the rule. If you broke this 88-year dataset in half by the volatility measures, the years with lower volatility far outperformed the years with higher volatility.
More telling is that in years where volatility recedes, stocks do much better than in years where volatility, on average, is higher than the previous year. The difference is stark. A dollar invested in those 49 years with declining volatility would turn into over $3,000; a dollar invested in those 38% years with rising volatility would turn into just over $3.
That begs the question of whether volatility will be high or low in 2022. It also begs the question of whether volatility will be rising or falling. My guess is that volatility will be higher in 2022 than in 2021; volatility was below long-run average in the past year, and at its lowest average level since 2017. In 2021, fiscal and monetary stimulus were always set to be a tailwind; in 2022, we expect both to be unwound to some degree. High current equity multiples, challenging macroeconomic conditions with high inflation, an ongoing pandemic, what will likely be a contentious mid-term election that slows fiscal support all serve as potential drivers of higher volatility.
Too Much of A Good Thing
There have been 17 years with higher returns than in 2021 - none of those years saw better returns in the next year. There have been 13 years with better risk-adjusted returns; only 1 year (1963/1964) saw better risk-adjusted returns the next year. Of the ten best risk-adjusted annual returns on record, none saw higher returns or even lower volatility the next year. The past year has been a good one. Financial market history suggests it will be difficult to replicate in 2022.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of SPY either through stock ownership, options, or other derivatives. 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.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore, inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.
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