The Bull Stock Market Needs to Give Credit to the Calendar
Returns this year look stellar, but only because equities collapsed the last month of 2018.
Bloomberg, December 17, 2019
Major U.S. stock markets, depending on which index you prefer, are up anywhere from 21% to 33% this year. Those are big gains, making this one of the best years ever. The results should include ripple effects for real estate and retail, as giant incentive fees, profit sharing and big bonuses work through the economy, benefiting everyone.
Well, not exactly.
Looking at market returns on a calendar-year basis can be misleading. Let’s use the broad benchmark of large U.S. equities, the S&P 500 Index, as our example. From the market close on Monday, Dec. 31, 2018, until today, the S&P 500 has gained 27.4%, or 30% including reinvested dividends.
But let’s use a slightly different time horizon — not a lot — starting from the Sept. 20, 2018, peak rather than the last day of last December. On that basis, the S&P 500’s returns have been almost 9% (more than 11% with dividends) and 9.4% on an annualized basis. Not bad, but not super either. What gives?
Much of the gains in this years’ markets are a quirk of that 2018 fourth quarter, which was a debacle no matter how you look at it. For a variety of reasons (recession fears, trade war concerns, Federal Reserve tightening, liquidity issues, volatility in repo markets and so on), U.S. stocks flopped into a 20% slump at year-end. That almost perfectly dovetailed with the calendar, and the market low landed on Christmas Eve day. The markets began to recover soon after. The result of that timing: Most of this year’s powerful market returns — almost 90% of them — are a recovery from that fourth-quarter plunge. Just by way of example, a 20% retreat requires a 25% rise just to break even. 1
Why does this matter? Calendar returns matter much less for your personal wealth than do net gains. To understand why, consider high-water marks and troughs. Where you start doing your measuring makes all the difference. Let’s consider just a few points:
• New Bull Markets: These pullbacks and recoveries affect how we date new bull markets. As we have noted before, bull markets are properly dated when they break out of earlier trading ranges to reach new highs that are above their prior high-water marks. As we have discussed before, this is why the current bull market dates to March 2013, and not to March 2009, which was the market low in the midst of the financial crisis. The sell-off and subsequent recovery — in the case of the Dow Jones Industrial Average, this meant a 7,000-point plunge and a 7,000-point rebound — was a wash for investment returns. Yes, if you bought at the very bottom, you recorded big gains. But most people didn’t. And if you rode the decline and recovery, all it did was bring you back to where you were before the crash. This same lesson needs to be applied every time a market stumbles and recovers.
• Your Portfolio: Investors have discussed with me their surprise that despite headlines trumpeting enormous market gains, they don’t seem to be a whole lot richer than they were a little more than a year ago.
There is a psychological reason for this: As Daniel Kahneman explained in his 2011 book “Thinking, Fast and Slow,” we have a tendency to judge things based on our perceptions of how they feel at their peaks and valleys (and also how they end). The peak–end rule is a memory bias where peaks stand out much more than the mundane events in between the highs and lows. Hence, you probably recall the previous highest value of your portfolio — September 2018 — much more vividly than the slow grind that simply amounted to a recovery during the following six to nine months.
There is no avoiding the peak-end rule, but it might help to annualize 2018-19 markets to understand why investors might feel a little let down. Rather than thinking of these two years as minus 6.2% and plus 29.8% (for the S&P 500, 2019 is year-to-date), it might be savvier to look at gains across those two years. In the case of the S&P 500, the gains total 24%, or 11.4% on an annual basis. Again, not bad and above average, but by no means stellar.
The good news is that markets that have had double-digit gains tend to keep rising faster than usual. Indeed, gains of this magnitude are the norm.
The real question is whether that streak continues in 2020 after a decade of surging equity markets. That, I’m afraid, is anybody’s guess.
1. Imagine a portfolio with a value of 100. After a 20% decline, its value drops to 80. To return to 100 requires a rise 20 points, which is 25% of that 80 value.
I originally published this at Bloomberg on Bloomberg, December 17, 2019. All of my Bloomberg columns can be found here and here.