So far this year (through August), the stock market, as represented by the S&P 500, is up more than 20%. We only had one month of decline, January, when the market fell only 1%. It’s a fantastic year to invest in stocks.
The climb was relatively calm and comfortable. No one knows what the rest of the year will look like, but it’s worth considering whether these returns are normal and investors are rational.
How much more than 20% is the stock market up in a calendar year? It may be surprising to learn that this is common.
In the 95 years from 1926 to 2020 for which we have S&P 500 data, the stock market (including dividends) grew by at least 20% in 35 of those years; that’s over a third of all calendar years! (There is nothing special about calendar years or months, but these are easy times to review the data).
More impressively, the market has grown 30% or more in 20 of those years. Given that the historical average market return is around 10%, it is remarkable to see these extraordinary returns with such frequency.
Of course, if there are to be exceptional years, there must also be bad years. A fundamental principle of investing is that risk and return are linked. You can’t get fantastic returns without potentially taking some risk of loss.
How often has the market performance been negative?
The stock market has experienced negative returns in just 25 of those 95 calendar years. Any investor understands the potential for short-term losses when investing in the stock market, but historically it is more common to see a gain of more than 20% than to see a loss in any given year. In short, people shouldn’t be surprised when we have a year like the one we’ve had so far in the market.
The data also shows that investors should not rely on long-term averages to estimate short-term results. The average annual return of the S&P 500 since 1926 has been just over 10 percent, yet over that entire period there have been only two calendar years that produced a return between 8 and 11 percent. Annual returns are rarely “average”.
One anomaly this year, however, is the regularity of positive market returns.
Most years have at least one bad month. The average worst month in a year is around 7.2%. Even during the 35 years with gains of at least 20 percent, the average worst month is negative 5.5 percent.
A loss of this magnitude in a month could be quite painful. Last year saw drops of 8.2% and 12.4% in February and March, at the start of the pandemic, even on track to a positive overall year. Even in 2019, when the market ended the year with a 31% return, there was still a 6.4% drop in May.
Aside from the 1.0% drop in January of this year, every month has been positive. The only year in the 95-year history of 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. the other was unusual.
Can this streak of consistent positive returns continue? Sure, but history suggests it’s unlikely. The ups and downs are a hallmark of investing in the stock market, and it would be unreasonable to always expect smooth sailing.
However, the timing of a withdrawal is unpredictable. Everything can happen; we may end up with another year over 20 percent, or a negative year, or something in between. Over a short period of time, say a year, returns are simply not predictable, as the market will react to new information (aka: “news”), which by definition is unpredictable.
It makes perfect sense that the markets have done well lately. Market prices are the consensus estimate of millions of market players and are not unfounded. The economy is currently doing very well, despite the ongoing pandemic. Corporate profits and [gross domestic product] growth has taken off in the last two quarters.
In addition, with interest rates still close to their historic lows, investors are showing a preference for investments in stocks over bonds. The Federal Reserve continues to be incredibly accommodating with its policy.
Shares represent the ownership of companies. Almost a quarter of the S&P 500 is [made up] from 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 huge prospects for profit growth.
There has never been a 20 year period in the history of the stock market with negative returns. The market will not grow indefinitely, but it is not crazy to expect long term growth. However, it would be safe to expect higher daily and monthly volatility than we have seen recently.