February, 2023
Many extreme events happened in recent years: a global pandemic, rapid burst of inflation, war in Europe, earthquakes, hurricanes, and floods in many regions and, last but not least, highly volatile financial markets. Hyper-focused media attention on terrifying events makes many feel that these times are especially uncertain, making them afraid to invest or to stay invested — even if sensibly planned.
Pretend now it’s the end of 2019. Prophetically you are shown the big events that occurred through the end of last year. Unfortunately, your vision included nothing about financial markets. Then you’re asked to predict and put money on how the U.S. stock market would perform. Will the overall market be up 25%? Flat? Down 25%?
Exhibit 1: Bigger Performance Picture
Growth of $1 invested in S&P 500 market index of U.S. stocks
January 2020 – December 2022
Source: Dimensional Fund Advisors. S&P 500 Index annual returns from S&P Dow Jones Indices LLC. Past performance is no guarantee of future returns. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Market decreased 19.6% from Jan. 1, 2020, to March 31, 2020.
Including 2022’s 19% decline, Exhibit 1 shows that the market was up almost 25% from 2020 through 2022. Since brokerage statements tend to show returns by a rolling twelve months, many are surprised. The longer-run context of returns — even for their own accounts — is ignored. Yet that information is crucial for planning long-term goals. It’s essential for deciding how much should be allocated to stocks rather than, say bonds.
Exhibit 2: Calendar-Year Distribution of U.S. Returns
Distribution S&P 500 index of U.S. stock market by yearly occurrence, 1926-2022
Source: Dimensional Fund Advisors. S&P 500 Index annual returns from S&P Dow Jones Indices LLC.
Exhibit 2 shows the distribution of annual stock returns over 97 years based on research-quality market data. It ranges from a year when the stock market lost almost 50% to two years when it gained more than 50%. The bulk of the returns are between –10% and +40%. Histograms give you a sense of return distributions, while not making an effort to forecast what the next year’s return will be. The best prediction of next year’s return would be a random draw from one of those 97 years.
Exhibit 3: Two Steps Up, One Step Down
Distribution S&P 500 index of U.S. stock market by yearly occurrence, 1926-2022
Source: Dimensional Fund Advisors. S&P 500 Index annual returns from S&P Dow Jones Indices LLC.
Rather than focus on 2022’s outcome in isolation, let’s include an outcome with the two years prior. In Exhibit 3, 2020 and 2021 returns were both positive. All considered, these three years comprise a full market cycle: two positive years and one negative. Looking back many decades, we also may see three positive and one negative. Markets broadly appear to move forward and backward in an equilibrium cycle that no one can consistently predict.1
Given so much bad news, how do we explain a longer-term positive stock market outcome? It’s because companies constantly innovate to figure out profit opportunities. When bad things happen, they don’t sit around and complain, hoping for another government rescue. Businesses respond creatively: when pandemic and lockdowns hit, markets dropped 20%.2 But a vaccine was invented and then quickly distributed. Businesses large and small adapted in a thousand ways to keep operating all during that time.
Exhibit 4: Recent Returns Align with Long-Term Market History
Distribution S&P 500 index of U.S. stock market by yearly occurrence, 1926-2022
Source: Dimensional Fund Advisors. CRSP data from Booth Business School, University of Chicago. One-month Treasury bill data by Morningstar.
Exhibit 4 compares returns from 2020-2022 and for 97-years of the S&P 500 index and US Treasury bills. In the 94-years of 1926–2019, the S&P 500 index compounded at 10.20% per year. Treasury bills, which are a kind of risk-free asset, compounded at 3.32%. The difference between 10.20 and 3.32 is 6.88 percentage points: that 7% represents the equity risk premium — the reward for bearing stock market risk.
In 2020-2022 shown in the middle row, the S&P 500 compounded at 7.66% and Treasury bills were 0.64%. The difference between those is 7.02 percentage points. Surprisingly, that result coincides closely with the 7% equity premium of 97 years of market history!
In other words, in terms of U.S. equity market returns, the last three years of history have been “normal.”
How can we explain “normal” returns when the media news machine keeps announcing one new crisis after another? Public financial markets are a gigantic information-processing machine. Whenever bad news negatively impacts business, prices drop. When good news arrives, prices rise. Each day stock prices adjust to induce people to invest. If the future outcome of every stock had negative expectations, no one would invest. Stocks constantly adjust their prices so their expected return is always positive. Capital is thereby allocated among companies into its highest and most productive use.
Conclusion
Contango in commodity trading is a situation when a futures price is higher than the currently traded spot price. A futures price will converge toward the expiration spot price. Stocks are not commodities and have no spot prices. Yet over a long time horizon, stock price equilibrium becomes a kind of “dance,” stepping forward and backward, as traders try to spot return opportunities from price changes, impacting the market as a whole. Market prices collectively dance moving ahead and then back over decades, constantly in search of an unknowable equilibrium.
Don’t lose sight of your long-term investment planning goals. Remember that uncertainty is what creates opportunity for investors. Stocks have higher expected returns than bond investments because they require bearing additional risk. Without uncertainty and its volatility, you wouldn’t get paid for bearing the risk of owning stocks.
What will happen over the next three years? I don’t know. The good news is, if you have planned well with an experienced CFP® professional, you don’t have to know. That’s because you’re likely not fixing your hopes for a secure future on making predictions.
NOTES
- 1Publicly at least. If they could, they wouldn’t tell you. They would borrow as much as they could to invest and keep all the gains.
- 2S&P data from S&P Dow Jones Indices LLC. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Decrease of 19.6% was from Jan. 1, 2020, to March 31, 2020.