What Happens After a Good Year for Stocks?
Key Takeaways
Bad years in the stock market tend to be followed by many good years in the stock market.
Positive returns tend to cluster together, and markets provide more positive returns than negative ones (from 1995 to 2023, 75% of the time, to be exact).
Data and research shows reaching a new high doesn’t mean the market will then retreat — more often than not, returns 1, 3, and 5 years after new highs are pretty similar to all other months.
As there are deeper explanations of why markets continue to go up over extended periods of time, several papers are linked in the article for those interested.
One market paradigm that I take exception to is: Buy low and sell high. I believe far more money is made by buying high and selling at even higher prices.
Looking back, 2023 turned out to be a decent year in the stock market. It did not appear so at the beginning of the year and during the seasonally weak months from August to October, but the strong performance during the last two months pushed the global stock index into double-digit return figures.
Often, bad years in the stock market are followed by good years in the stock market, although this is not always the case — especially if the world is beset by an extremely large economic contraction. The chart below shows the return of a diversified basket of global stocks (both developed and emerging countries) since 1995.
You will notice that apart from the dot-com collapse in 2000-2002, most bad years are followed up by good years. In addition, positive returns tend to cluster together and if you were to count the number of positive return years vs. negative years, you will get a ratio of 3 out of 4, or 75%. This shows that markets provide positive returns majority of the time.
However, with positive performance comes a problem. We often get anxious when markets move up especially when headlines are shouting “all-time highs”.
We are pleased to see our investment holdings gain in value but at the same time are worried that higher prices somehow foreshadow a dramatic “reversion to mean” in the future. As such, when looking to deploy capital, we may hesitate to make new purchases since the traditional “buy low, sell high” mantra suggests committing funds to stocks at an all-time high is a surefire recipe for disappointment.
When looking at how the stock market has reacted over the many decades, you may be surprised to find out that the average returns (taking the S&P 500 Index for its long history) one, three, and five years after a market high are similar to all other months.
The chart below shows monthly closing prices for the US stock market from 1926 to 2022 — of which there were over 1,100 observations. Out of these, over 340 were market highs. After those highs, the returns were then measured and it turned out to be not very different. As such it appears that stock markets don’t “revert to the mean” as often as you might expect.
There are explanations of why markets continue to go up over extended periods of time. For one, it is the momentum of the market which various research papers try to explain (links here, here and here, for those interested to delve further).
There’s also the expectation of increasing dividends and future cash flows from investing in companies around the world which leads investors to deploy more capital into markets. If majority of people around the world expected companies to deliver dwindling future returns, then expectations of the market would be negative. Then nobody would want to invest in stocks anymore.
So, would 2024 be a good year for stocks? History suggests that it could be, and it has shown that reaching a new high doesn’t mean the market will then retreat. In fact, stocks are priced to deliver a positive expected return for investors every day, so reaching record highs with some regularity is exactly the outcome one would expect.
Nevertheless, we are likely to face many hurdles and uncertainty along the way and that is exactly one of the key reasons why we are here to guide you, our clients and investors along the bumpy path to your goals. If you would like to find out more about how we can help you better, come and have a chat with us.
