Navigating market highs and lows

As of September 30, 2024, the S&P 500 has experienced a remarkable surge, rising 36% over the previous twelve months. While this impressive performance has undoubtedly brought a sense of optimism to many investors, history offers us valuable lessons on what such significant gains might mean for future returns.

A quick history lesson

Since 1927, whenever the market has risen by 36% or more within a four-quarter period, the subsequent four-quarter average return has been approximately 3%. Furthermore, the average return over the following five years tends to be less than 2%. These statistics suggest that after a year of exceptional growth, the market often enters a period of more modest returns.

Conversely, during periods when the market has experienced significant declines, the average return in the following year has been around 21%, with a five-year average return of 12%. This pattern indicates that downturns can create opportunities for substantial gains as the market recovers.

The current surge in the S&P 500 can be attributed to several factors, including strong corporate earnings, favorable economic data, and investor optimism. However, it’s essential to recognize that such rapid growth can also lead to increased volatility and potential corrections. As portfolio managers, we remain vigilant and cautious, understanding that the market’s current trajectory may not be sustainable in the long term.

Market downturns following well-above-average returns

The following can be factors in market downturns after periods of above-average returns.

• Profit-taking. After a significant rise in stock prices, investors often sell off their holdings to lock in profits. This increased selling pressure can lead to a market downturn.
• Valuation concerns. When stock prices rise rapidly, they can become overvalued. Investors may start to question whether the high prices are justified by the underlying fundamentals, leading to a market correction.
• Economic cycles. The economy moves in cycles of expansion and contraction. After a period of rapid growth, economic indicators may start to show signs of slowing down, prompting concerns about future growth prospects.
• Interest rate changes. Central banks may raise interest rates to curb inflation during periods of strong economic growth. Higher interest rates can reduce consumer spending and business investment, leading to slower economic growth and lower stock prices.
• Market sentiment. Investor sentiment can shift quickly. After a period of strong returns, any negative news or economic data can trigger a change in sentiment, leading to a sell-off.

Strong results following poor market performance

Conversely, the following can be factors for market upticks after periods of poor market performance.

• Valuation opportunities. After a significant market decline, many stocks may be undervalued. Savvy investors often take advantage of these lower prices to buy quality assets at a discount, leading to strong subsequent returns.
• Economic recovery. Market downturns are often followed by periods of economic recovery. As economic conditions improve, corporate earnings typically rebound, driving stock prices higher.
• Monetary and fiscal stimulus. In response to economic downturns, governments and central banks often implement monetary and fiscal stimulus measures. These actions can boost economic activity and investor confidence, leading to market gains.
• Improved investor sentiment. After a market decline, investor sentiment can improve as economic conditions stabilize and growth prospects become clearer. This renewed optimism can drive stock prices higher.
• Reversion to the mean. Markets tend to revert to their long-term average returns. After a period of poor performance, the market often experiences a rebound as it moves back toward its historical average.

What this could mean for you

Understanding these historical trends is crucial for managing expectations and making informed investment decisions. Here are a few key takeaways:

• Temper your expectations. After a year of extraordinary gains, it’s essential to temper expectations for the near future. While the market may continue to grow, the pace is likely to be slower. Investors should be prepared for potential corrections and periods of lower returns.
• Diversification is key. Maintaining a diversified portfolio can help mitigate risks. By spreading investments across various asset classes, you can better navigate periods of lower returns. Diversification can also provide a buffer against market volatility, ensuring that your portfolio remains resilient in the face of potential downturns.
• Stay the course. Market fluctuations are a natural part of investing. It’s important to stay focused on your long-term financial goals and avoid making impulsive decisions based on short-term market movements. A disciplined approach to investing, grounded in a well-thought-out strategy, can help you weather market ups and downs.
• Look for opportunities in downturns. Historically, market downturns have presented opportunities for significant gains. If the market experiences a decline, it may be a good time to consider strategic investments. By identifying undervalued assets and taking advantage of lower prices, you can position your portfolio for future growth.

While the S&P 500’s impressive performance recently is encouraging, it’s important to remain mindful of historical trends and manage expectations accordingly. By staying informed and maintaining a diversified, long-term investment strategy, you can navigate the many ups and downs of the market with confidence.