How long can the market stay like this? Maybe years or decades (SP500)

By Rob Isbitts

I thought of telling this “story” through technical charts: support and resistance levels, trading ranges, historically very overvalued technical indicators, etc. But there’s plenty of time for that in future articles. Instead, here’s another way to communicate the same conclusion:

Future stock returns could disappoint many investors for years to come

This is not a prediction. It is, however, a high probability, based on my decades of studying markets and market participants (I was an investment adviser for 27 years and wrote in the public sphere for over 20 years) . You see, trees don’t grow up to the sky. And stock market returns generally don’t moderate over time…they plummet. This sequence may take a few years. Yet the current group of market players may not have a sense of history aside from the flash-crash of 2020 and the single-year bear market of 2022. As we invest, the “oldies” might say… but wait, there’s more. Here is the plus for you. I hope this helps bring a perspective that helps understand where we are in the story and what might happen next. Not just in 2023, but over the next few years, even the next decade.

A conducted a research study to answer the following questions about the S&P 500 Index:

1. Is a down year in 2022 that bad?

2. What does stock market history tell us about a year of decline following a very strong multi-year period?

3. Is market history really a good guide?

Methodology

I went back to 1975, in order to have a sufficient sample size of annual returns. I converted this annual data into “rolling” periods of 5, 10 and 15 years. This is a long-term study, although, as you will see, it has serious immediate implications for some investors.

I used price returns, not total returns. In other words, I excluded dividends. I wanted to focus on price changes because stock dividends are historically low and have been for a long time. Dividends may indeed be a bigger factor in future returns, but I didn’t want to put that bias into this retrospective review. I will be writing a lot about dividends in the months to come. I am, after all, the founder of Modern Income Investor.

punch lines

The chart above is for investors who just want the “score lines” here. The information below is getting more and more granular. So choose how far you want to read. I will repeat the 3 questions above and deliver my answers.

1. Is a down year in 2022 that bad?

Yes. Because this year has been marked by a real change of course. Inflation, higher interest rates, and the Fed keeping everyone on their toes (or, seen another way, confusing us all), via ever-changing rhetoric. And, as my study shows, stock market investing tends to be more party than starvation, with far less in between. In this table above, note these boxes at the bottom. These summarize the nearly 50 years of annual return data that I highlight here but show in detail in a table at the bottom of this article.

Almost a third of the time, the S&P 500 has produced a price return of less than 15%. This is a cumulative return figure, not annualized. That is a return of less than 3% per year for 5 years, excluding dividends. That’s one mile below the current rate of inflation. And that is likely to frustrate the masses of today’s more immediate-gratification investors. That’s what frustrates a lot of us market veterans right now: that the market hasn’t cleared out so that a real new equity bull market can begin. Instead, we have this endless dance, with trash stocks bursting at any sign of life it interprets from the Fed. This obsession is not healthy in the long run. In my view, a down year is not a big deal for many investors. Give them a second, and it will start to infect the psyche.

And that’s what this data tells me. Because once the good times that are supposed to be forever start to fade, that boiling frog analogy starts to seep into the psychology of the market. That is, market emotions range from “I’m okay with a drop in my stock portfolio because it always comes back strong.” This graph shows that this is historically false. Because not only do we have the data that shows that 1/3 of the time you earn a measly 5 year return for taking on all that market risk. When we look at 10 and 15 years, we see that poor returns can be contagious. I chose a 10-year price change of 40% and a 15-year price change of 60% as the dividing line between “I’m okay with that” and “why am I bothering to invest further in the stock market”.

As you can see, about 25-30% of the time you can get back to your S&P 500 index fund and what you’ve earned, excluding dividends? Less than 4% per year if you use a simple average, and plus or minus 3% if you use a compound return approach. There was a time when investors didn’t just say they were “long-term investors”, they meant it. We have yet to see if the modern investor is as patient. Call me skeptical. That’s why I’ve dedicated the rest of my career to thinking outside the box. Because someone has to.

2. What does stock market history tell us about a year of decline following a very strong multi-year period?

That these lower timeframes of 5, 10 and 15 years tend to come in clusters. And that they tend to start with a single down year following a historically hot period for the S&P 500. You know, like we have right now. Here is the 5-year price performance of the S&P 500 for a very long time. Note that when this 5-year figure goes above 100% and then starts to fade, it’s usually the start of a trend.

Now take a look at the chart above. This area highlighted in yellow tells us that, barring a miracle in the coming weeks of December, this 5-year rolling yield will drop from 113% to less than half. Historically, this is how the long-term trend change begins.

I will also add this: it is rare that the 5, 10 and 15 year yields all fall in the same year. When it does, it usually means we’re in the middle of a bigger deal than a down year that simply picks up at the start of the next year. See the “busy” history table at the bottom of this article for this detail. Or, if you prefer, visualize it by looking at the 10- and 15-year rolling price charts for the S&P 500 here.

3. Is market history really a good guide?

We are about to find out. Years ago, all that Fed rhetoric and 24/7 market coverage didn’t matter because most people weren’t investors. And we didn’t have 24/7 coverage. You looked at the Wall Street Journal or your local newspaper to find out what happened yesterday.

We didn’t have the army of self-directed traders and investors that we have now. While the acceptance of investing in the mainstream is nice to see, it also challenges what is still working.

Then instant communication kicked in and gave the investment firm its biggest “hold my beer” moment ever. Want to be up to date? Now you have everything you can handle. And frankly, more than most can handle, considering many investors’ poor performance this year, the first time in their investing lives that the wind wasn’t at their back.

Next year we should know a lot more. 2022 will either be an anomaly in a continuous secular bull market or it will conform more to what has happened in the past. My hunch is that 2023 will be another down year for the stock market. I will have a lot more to say about this in the transition from 2022 to 2023. But for now, my goal is that despite all the modern adjustments to how markets, investments and communication work, there is always an element of human emotion and thought behavior patterns that never go away. It does, no matter how hard a few big corporations try to alter how our brains work.

Conclusions (so far)

This stock market is in trouble. One year of decline is probably not enough to purge the decade of easy money and the speculation in the investment market it has caused. We’ve moved from the buy-and-hold era to 2022, where you can trade S&P 500 options contracts that expire on any trading day of the year. It’s progress…sort of, anyway. But as I see it, it’s all part of the risk denouement that past investing eras teach us, but which are largely in denial as a calendar year stock market decline winds down.

What can change this course? If the market has shifted to a permanent state of positive vibrations. I know the past quite well. I don’t know yet if my vision of the present is correct. I think we will all soon know where this is taking us. That is, whether history is the best guide, a good guide, or has been rendered irrelevant.

Finally, here is that more detailed chart to back up my numbers and opinions above. Enjoy.