As someone who manages investment portfolios for a living, one of the most common questions I get from friends, family, and random people sitting next to me on a plane is some variation of “so where do you think the market is headed?” My usual response is to give the basic academic answer that the market is efficient, and any predictions into the future is purely speculative and should be avoided. While this still may be true, but the question has a bit of a different feel recently. After all, we are still in the midst of a global pandemic which shut down parts of the economy for months and counting, and the market responded by…hitting all-time highs? As a result, the tenor of this question has changed from speculative to exasperation. Many people I’ve spoken with recently are truly wondering where the market can go from here. At basic levels, the concern makes sense. What is the justification for market being at all-time highs given the bad economy? Even if it doesn’t drop back down, how can it possibly continue to rise?
To answer these questions, we need to provide some context as to exactly what has happened and let history shed some light on what we can expect going forward. So what has happened? Well the chart below is what has everyone so puzzled and concerned.
As we can see, GDP growth fell off a cliff, dropping a staggering 32% relative to the growth rate a year ago. Meanwhile, the S&P 500 had a sharp downturn near the beginning of the lockdown, but has come all the way back and then some, even as the economy continues to lag. This absolutely doesn’t make sense at first blush, and anytime that is the case the answer almost always lies deeper in the details. In this case, there are 2 primary reasons.
The first and probably most relevant is that the economy is NOT the market. The economy is a measure of the what is currently happening, where as the market is forward looking. Stocks are priced based on their prospects to make profits in the future. There are times where a common variable effects both of these. In a structural recession like 2008, it makes sense that stocks would also suffer right alongside the real economy. However, an event-driven recession like the Coronavirus obviously has a dramatic impact on the economy in the short run, but there’s some expectation of things returning to normal once the pandemic ends. As a simplistic example, If I run a lemonade stand and get a bad batch of lemons, this is an event-driven disruption, but I don’t get concerned about the long-term prospects of my business. If new research comes out saying lemonade is toxic, this would be a structural change and the value of my business would decrease substantially.
The second reason for the seeming contradiction is that the composition of the S&P 500 skews our impression of how the stock market has performed. I’ve discussed this in other posts, but it bears repeating. We generally use the S&P as a proxy for the whole market, but consider these statistics:
Globally there are about 630,000 stocks
In the U.S. there are around 19,000 stocks
The S&P 500 contains 500 stocks. Almost every one of these is larger than almost every one of the 18,500 US stocks not included.
37 of these companies comprise 50% of the weight of the S&P 500
5 of these companies comprise 25% of it.
The Dow and the Nasdaq have very similar breakdowns. Does it make sense that the entire stock market rose as the economy shrank? No. But does it make sense that some relatively small number of companies were largely unaffected or even thrived during this time period? Absolutely. This is exactly what happened. The pandemic was not an equal opportunity business killer. Most of these large firms that dominate the indices were in technology or technology driven, had massive distribution networks, and had plenty of cash on hand to weather a small blip if there was one. The ability of these type of companies to generate future profits was not put in peril, and therefore their valuations were largely unaffected. The performance of other parts of the market are much more reflective of what our intuition tells us. This is the same chart as above, but replacing the S&P with indices that measure both US and International Small/Value stocks.
It’s clear from these charts that many companies didn’t fare as well as those driving the return of the major indices. Perhaps a more interesting way to look at this is to see the performance breakdown by individual companies. The Russell 3000 is comprised of 3000 US stocks that cover a broad swath of the US stock market, including large and small stocks as well as growth and value stocks. Below is a histogram of the returns of these companies YTD.
There are 2 things that really stand out from this chart.
- There is a lot more red than blue. Red represents the returns ranges that are negative. Of the roughly 3000 companies, Less than 1/3, or about 900 have a positive return YTD.
- There is a fat tail on the right. That means there are a small number of companies that have produced dramatically above average returns.
In addition to this being a nice graphic to show us a more pure representation of what the “market” has done of late, it’s also a great visual showing the difficulty of having success picking individual stocks. In year where the Dow is hitting all-time highs, about 70% of US companies lost value. More on that in another post.
While this may provide some justification for how the market is currently priced, the 2nd part of the original query remains – How can the market go up from here?
Although this question is magnified by the current recession, it is one we get often regardless of economic conditions when we hear markets are at all-time highs as we are today, or at times where we’ve seen a prolonged bull market as we have since 2009. Neither of these scenarios is unique, so I thought it could be useful to see how the market performed historically following these events. The first question of performance following all-time highs is a little bit of a silly one, as we know the market grows consistently in the long-term and will therefore continually hit all-time highs, but let’s see what the data shows since 1926, looking at all months with 10 years of data following:
First, almost 30% of all months finish at all-time highs, so this obviously isn’t an uncommon occurrence. Second, there’s basically no difference in the 10-year return following these occurrences.
The 2nd part of the question is looking at market performance following a long run-up. Over the last 10 years, the S&P 500 has made 14% per year annualized. So how many 10-year periods have closed finished with an equal or better previous 10 years? And what was the return following those years?
It’s surprisingly even more common than our first data set, with over 1/3 of 10-year time periods having finished with an annualized return of > 14%. The return following these periods was literally identical to all months, down to the tenth of percent. So while we have seen a good run over the last 10 years, it’s certainly not historically unprecedented, and there’s no reason to think the market can’t continue to go up following this run-up.
For the last point, I want to bring this conversation full circle. I initially made the case that the S&P 500 was not a good representation of the whole market, then subsequently looked at S&P 500 market history. The reason is that the S&P 500 IS what has hit highs and run up greater than average recently. But if the last studies aren’t convincing, and one truly does think this part of the market is overpriced, the important thing to know is that this is not the case for the rest of the market. A diversified portfolio holds parts of the market that are actually coming off of time periods of substantial underperformance, as highlighted below. If the idea is that recent over-performance means there is less room to grow, then by that same logic these other asset classes have substantial room to grow.
To summarize the key points:
- The economy is NOT the market.
- The major indices have hit all-time highs, but much of the market is still down from previous highs.
- Market returns following all-time highs are not lower than average.
- Market returns following run-ups like we’ve seen are not lower than average.
- Many asset classes have performed below historical averages and are not at risk of being near the top of a bubble.
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