Looking back to early 2022, after two extraordinary years market forecasts called for an ‘average’ year. Instead, we had a year marked by extremes, almost all bad: U.S. equities were down roughly 20%, the weakest performance since 2008, while bonds posted their worst performance in decades.
Following last year’s trauma, many investors are once again expecting a return to normal. A cursory look at how stocks perform following down years would confirm this view. However, when you look under the surface history suggests 2023 is more likely to be another year of extremes.
As most investors realize, even modest down years are relatively rare. Beginning in 1945, the S&P 500 has posted positive annual price returns more than 70% of the time. And when down years do occur, the average return the next year does trend towards average, roughly 9.5%.
A wider range of outcomes
However, on closer inspection years following down years are more interesting and less normal. While the average return following down years is in line with the long-term average, this measure conceals a good deal of variation. If anything, the years following down years tend to be either very good or very bad but rarely average.
We see this in a few ways. In a typical year, market volatility, measured by the standard deviation of returns, is around 15%. In years following negative returns, the standard deviation is closer to 25%. The difference is a function of a tendency towards a wider range of outcomes following years with negative returns.
For example, generally any negative return qualifies as a bottom quartile outcome. In contrast, in years following down years we see the cutoff for the bottom quartile at -10%. Same story for what qualifies as an exceptionally good year. The cutoff for the top quartile rises from 20% to 26%. In other words, in these years there is more of a tendency to post either particularly bad or very good returns.
While it’s easy to get into trouble confusing statistical quirks with tradeable patterns, looking through the data does suggest these return cycles are grounded in fundamentals. To the extent down years are a function of an economic soft-patch or a mild tightening cycle, markets typically stage quick and powerful reversals, as was the case in 2019.
Conversely, back-to-back negative years tend to cluster around two conditions: extreme valuation, as was the case in 2000-2002, or structurally high inflation, as was the case in the early ’70s.
It comes back to inflation
While U.S. valuations were elevated a year ago, they were nowhere near the tech-bubble peak. And following a year of brutal multiple compression, multiples are now back around the post-GFC average. This suggests that inflation will once again be the key swing factor. To the extent history is a guide, if the Federal Reserve can bring inflation down in short order, this would suggest stocks not only advance but post a particularly strong year. If the fight against inflation drags on, investors may need to brace for another year of material losses.