market

The author says that if there are going to be outstanding years for the stock market, there must also be bad years. A primary principle of investing is that risk and return are related. You can’t have fantastic returns without potentially taking some risk of loss.

So far this year (through August), the stock market, as represented by the S&P 500, is up more than 20 percent. We’ve had just one down month, January, when the market declined by just 1 percent. That is a fantastic year to be invested in stocks.

It has been a relatively calm and comfortable ride upward. Nobody knows what the rest of the year will look like, but it’s worth exploring whether these returns are normal and whether investors are being rational.

How typical is it for the stock market to be up more than 20 percent in a calendar year? It may be surprising to learn that this is common.

In the 95 years from 1926 through 2020 for which we have S&P 500 data, the stock market (including dividends) has risen by at least 20 percent in 35 of those years; that’s more than one-third of all calendar years! (There is nothing special about calendar years or months, but those are easy periods for which to review the data).

Even more impressively, the market has risen by 30 percent or more in 20 of those years. Given that the historical average return for the market is around 10 percent, it is remarkable to see these extraordinary returns with such frequency.

Of course, if there are going to be outstanding years, there must also be bad years. A primary principle of investing is that risk and return are related. You can’t have fantastic returns without potentially taking some risk of loss.

How often has the market return been negative?

The stock market has seen a negative return in just 25 of those 95 calendar years. Any investor understands the potential for short-term losses when investing in the stock market, but it is more common, historically, to see a gain of more than 20 percent than it is to see a loss in any given year. In short, people should not be surprised when we have a year like the one we have had so far in the market.

The data also reveals that investors should not rely on long-term averages to estimate short-term outcomes. The average annual return on the S&P 500 since 1926 is just over 10 percent, yet, over this entire span, there were only two calendar years that produced a return between 8 percent and 11 percent. Annual returns are rarely “average.”

One anomaly this year, however, is how consistently positive market returns have been.

Most years have at least one bad month. The average worst month during any year is about negative 7.2 percent. Even during the 35 years with gains of at least 20 percent, the average worst month is negative 5.5 percent.

A loss of that magnitude in one month could be quite painful. Last year brought declines of 8.2 percent and 12.4 percent in February and March, at the outset of the pandemic, even on the way to a positive overall year. Even in 2019, when the market ended the year with a 31 percent return, there was still a decline of 6.4 percent in May.

Aside from the 1.0 percent dip in January this year, every month has been positive. The only year in the 95-year history of the S&P 500 data without a negative month was 2017. In other words, the magnitude of returns this year is not uncommon, but the lack of month-to-month volatility has been unusual.

Can this stretch of steady, positive returns continue? Sure it can, but history suggests that is unlikely. Ups and downs are a signature of investing in the stock market, and it would be unreasonable to always expect smooth sailing.

However, the timing of a pullback is unpredictable. Anything can happen; we may end up with another 20-plus-percent year, or a negative year, or anything in between. Over a short period such as one year, returns are simply not predictable, because the market will react to new information (aka: “news”), which, by definition, is unpredictable.

It is perfectly rational that markets have done well in the recent past. Market prices are the consensus estimate of millions of market participants and are not unfounded. The economy is currently doing very well, despite the ongoing pandemic. Corporate profits and [gross domestic product] growth have soared in the last two quarters.

Moreover, with interest rates still near historic lows, investors are revealing a preference for investment in stocks as opposed to bonds. The Federal Reserve continues to be incredibly accommodative with its policy.

Stocks represent ownership in companies. Nearly one-quarter of the S&P 500 is [made up] of Apple, Microsoft, Amazon, Google, Facebook and Nvidia. When you own the stock market, you own a share of these tech giants, all of which have tremendous prospects for earnings growth.

There has never been a 20-year period in the history of the stock market with negative returns. The market won’t go up unabated forever, but it’s not crazy to expect growth over long-term periods. However, it would be prudent to expect more daily and monthly volatility than we’ve recently experienced.

Luke F. Delorme is director of financial planning at American Investment Services in Great Barrington. He can be reached at LukeD@americaninvestment.com.