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The broad stock market's nearly 30% return this year virtually guarantees that equities will perform handsomely in 2014 as well, right?
If only it were so easy.
The truth of the matter is that the stock market's performance next year has nothing to do with how it has performed this year.
Unfortunately, this hasn't stopped any of a number of commentators from arguing to the contrary. Ryan Detrick, Senior Technical Strategies at Schaeffer's Investment Research, recently pointed out that in each year since 1991 in which the S&P 500 (.SPX) gained at least 20%, the stock market invariably rose the next year as well.
And though the record of subsequent years being up wasn't perfect when he extended his analysis back to 1975, the results were still encouraging: "Since 1975 (whenever the S&P was up at least 20%), the following year is up a very impressive +12.84% and up 82% of the time. In other words, better returns than the average year."
Sam Stovall, Chief Equity Strategist for S&P Capital IQ, also jumped into this act earlier this week, commenting to clients that "'good' years typically follow 'great' ones. Since 1945, there have been 21 times that the S&P 500 gained more than 20%. In the following year, the S&P 500 recorded an average increase of 10% vs. an average price gain of 8.7% for all years since WWII. In addition, these "good" years recorded a positive performance 78% of the time vs. a 71% frequency of advance for all years."
Unfortunately, none of these results is meaningful. From the perspective of standard tests of statistical significance, either the sample size is too small to draw robust conclusions, or the differences are not large enough to be significant — or both.
In fact, the stock market's odds in a given year are almost completely independent of what it did in the previous year. The accompanying table summarizes what I found upon analyzing the Dow Jones Industrial Average (.DJI) back to the late 1890s, when it was created.
|Probability that stock market rises in subsequent year||Average subsequent year gain|
|Whenever market is up at least 20% for the year||64.5%||7.4%|
|All years other than when market gains more than 20%||65.9%||7.2%|
|Whenever market is up for the year||65.3%||6.6%|
|Whenever market is down for the year||65.0%||8.4%|
|All years since 1896||65.2%||7.2%|
Notice that, upon focusing on the entire period back to the 1890s, the apparent advantage the market has following 20-plus-percent gains complete disappears. In fact, it now appears as though the market enjoys a slight advantage following years in which the Dow fell — though, I hasten to add, this advantage is not statistically significant.
We shouldn't be surprised by these results. The stock market's returns in any given year are independent of what happened before. Just as a coin doesn't remember whether its previous flip came out heads or tails, the stock market focuses on the future — not the past.
If the market did take the past into account, it would suffer from "unnecessary and unhealthy turmoil," according to Lawrence Tint, a chairman of Quantal International, a firm that conducts risk modeling for institutional investors. In an interview, he said "We can be comforted by the fact that reasonably efficient markets always base their level on anticipated future returns, and do not include history in the calculation."
Notice that this doesn't mean the stock market can't perform well in 2014. The point is that, if it does so, it will have nothing to do with its performing so well this year.
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