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Here's the truth about the stock market in 16 charts

As markets reporters, our most important responsibility is to provide readers with some helpful context for what’s going on. This is particularly important during periods of heightened volatility like what we’ve been experiencing for the past few months.

For this post, we’re going to skip the laundry list of reasons why stocks might be getting whipsawed right now. Rather, we’re gonna think longer term and bigger picture.

Every major sell-off in history has been accompanied by a mix of economic concerns, monetary policy shifts, geopolitical tensions, or some other source of consternation that might make a rational person demand a higher premium for putting their capital at risk. The details are different each time. But structurally, it’s generally the same story: it’s risky out there.

Amid all this, one pattern has stood the test of time: stocks will go down a lot, but then they will go up a lot more.

The explanation behind this is complicated. But ultimately, it’s about people wanting a better future. Human ingenuity develops the technology and processes that make the goods and services we want and need cheaper and more accessible. Standards of living go up for more and more people, and aggregate demand and profits go up.

It’s important to note that a major reason why the big stock market indices go up is because obsolete companies die and are regularly being replaced by innovators and disruptors who have all sorts of growth ahead of them. Turnover in the S&P 500 is very high as the life of an S&P 500 company gets shorter and shorter. The Dow Jones Industrial Average of 1896 looks nothing like the Dow Jones Industrial Average of today.

Let’s go to some charts.

From Credit Suisse’s Lori Calvasina, here’s how the S&P 500 has tumbled from peak to trough around recessionary periods. During these challenging economic times, the S&P 500 has averaged a decline of 33% during recessionary pullbacks. While a recession isn’t the base-case scenario for most economists right now, concerns of a recession happening soon are high. If you fear a recession is imminent, here’s some context.

Next, Calvasina illustrates how the S&P 500 soars from trough to peak around those same periods.

“Since 1929, the S&P 500 has averaged a gain of 62% during recessionary rebounds,” Calvasina observed. “Recessionary rebounds in the S&P 500 have had an average duration of 284 trading days, and a median duration of 298 trading days.”

Using some very basic maths, if you fall 33% and then surge 62% from that low level, then you are up 9% from where you started.

In other words, the cumulative gains of the stock market far outpace the cumulative declines.

Everything we’ve talked about so far is captured nicely in this next chart from JP Morgan Asset Management’s David Kelly, which is on a log scale and includes annotations of major world events.

We like to think of this chart as how Warren Buffett sees the stock market. Indeed, it echoes the message of a New York Times op-ed Buffett wrote during the darkest moments of the financial crisis. Here’s the key excerpt:

…A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 per cent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497

It’s worth noting that the Dow is at 16,267, up 41% from the 11,497 level Buffett mentioned in his 2008 piece.

Bottom line: investing can be scary. And you can very well get decimated in the near-term. But if you’re managing your risk properly and you have the time and the stomach for the volatility, it can be very lucrative and a whole lot of fun.

…well, at least that’s what the history shows.

Having said all that, let’s take a look at a couple more charts that offer some helpful context for stock market investors.

The stock market can wipe you out.

Citi Research

'Figure 45 shows various markets and industries which have suffered severe losses in relatively short order in recent decades, e.g., the UK (1972-74), the Nasdaq (2000-03), Greece (2008-12) and Mining (2008-09),'Citi's Jonathan Stubbs wrote.

'Hence, buyer beware.'

In any given year, a huge sell-off is probably going to happen.

JPMorgan Funds

'Despite average intra-year drops of 14.2%, annual returns positive in 27 of 36 years,' JP Morgan Asset Management's David Kelly observed.

Average returns rarely happen.

'Since 1926, the average annual return for US stocks has been a little more than 10%, and this seems to be pretty common knowledge for even neophyte investors,' Vanguard analyst Donald Bennyhoff wrote. 'So 10% would seem to be a reasonable expectation for an average year, right? Our illustration ... shows how often that assumption is erroneous, but it is also irrelevant.'

Past performance is no predictor of future returns.

Bank of America Merrill Lynch

'We find no relationship between historical five-year returns and subsequent 12-month returns,' Bank of America Merrill Lynch's Savita Subramanian wrote.

Using some simple regression analysis, she found an R-square of 0.0002. That's about as low as R-square gets. (R-square is a statistical measure that reveals how well a regression line -- the line of best fit you see -- explains the relationship between two variables. The higher the R-square, the better that relationship is explained.)

See also: 'These 0s prove past performance is no guarantee of future success'

It's common to see the market do the exact opposite of what would seem to be rational.

FactSet

'While the bottom-up EPS estimate declined during the fourth quarter, the value of the S&P 500 increased during this same time frame,' FactSet's John Butters observed. 'From September 30 through December 31, the value of the index increased by 6.5% (to 2043.94 from 1920.03). This marked the 14th time out of the past 20 quarters in which the bottom-up EPS estimate decreased while the value of the index increased during a quarter.'

Valuation does not do a great job of predicting near-term returns.

BAML

'Our work suggests that valuation is a poor short-term timing indicator, but the single-most important determinant of long-term returns,' Bank of America Merrill Lynch's Savita Subramanian said.

'Valuations have historically explained 60-90% of subsequent returns over a 10-year horizon. Normalized P/E -- our preferred valuation metric -- has explained 80-90% of returns over the subsequent 10-11 years.'

See also: 'Everything we know about PE ratios crammed into a useful, yet somewhat confusing chart'

Importantly, a rich valuation is no sign of a dying bull market.

BMO Capital Markets

'(W)e have found that the average P/E at the end of prior bull markets has fluctuated rather significantly, averaging 18.4x but with a standard deviation of 5.4x,' BMO's Brian Belski observed. 'This suggests to us that valuation by itself is not reason enough for a bull market to end.'

Even Robert Shiller's venerable measure of value isn't great at predicting what's coming in the near term.

Credit Suisse

'We admit that historically a high Shiller P/E has often resulted in subsequent negative returns; however, this has not always been the case and there are several examples where subsequent 3-year returns surpassed 20%,' Credit Suisse's Andrew Garthwaite said.

Using a hundred years' worth of Shiller's data, Garthwaite charted the observed three-year forward returns for various levels of Shiller's PE. The red rectangle sums up the observed three-year forward returns when the PE was at levels not long ago.

Currently, Shiller's PE is at 24.1, which in the past has seen returns above 20% and worse than -30%. Some returns were just lacklustre. Indeed, the range of returns is very wide. In other words, the signal is very ambiguous.

Valuations become more useful the longer your time horizon.

JPMorgan Funds

On the left, you see the historical one-year returns on the S&P 500 at various levels of the forward P/E. As you can see, the observations are scattered. There've been times when the market has been very expensive, yet delivered huge one-year returns. There've also been times when the market's been cheap, yet delivered crummy returns.

Bottom line: The popular forward P/E is terrible at predicting what the market is about to do.

However, don't ignore the chart on the right. It plots the five-year returns at those same historical forward P/E levels. As you can see, when you extend the holding period, the forward P/E becomes a more reliable metric.

So we're left with two lessons: 1. Don't rely on forward P/E to make short-term trades in the market, and 2. Be patient in your investing strategy, because theory and practice are more likely to align if you're in it for the long term.

Generally speaking, high valuation stocks don't do great.

Barclays

'Buying stocks with high PE ratios has not been a good strategy,' Barclays Jonathan Glionna observed.

Figure 14 shows the performance of a strategy that went long stocks with high PEs and short stocks with low PEs. Over the last 25 years, that strategy would have resulted in substantial losses. Overall, we believe high revenue growth strategies should be pursued with a cautious approach and not chased when the price is high -- as it is now.'

Even big long-term bull markets have crashes in them.

BMO Capital

BMO's Brian Belski recently
reminded clients that a bout of weakness and volatility fits into the narrative of long-term, secular bull markets.

'(I)t is important to note that the market has entered a secular stage where shorter-term volatility tends picks up, particularly considering how long the market has gone without exhibiting a major correction,' Belski said. 'Therefore, even if market struggles persist or enter outright 'bear market territory' over the near term, we believe it should have no impact for those investors with a longer-term focus.'

This chart of the current cycle (dotted red line) is overlaid with the average trajectories of the last two secular bull markets (solid blue line). Note the big dip in the blue line after year five. That's Oct. 19, 1987, the day the Dow plunged a breathtaking 22% in one day.

But in the long-run, stocks go up.

JPMorgan Asset Management

Panicking is costly.

Bank of America Merrill Lynch

'We compare a buy-and-hold strategy vs. a panic selling strategy from 1960-present,' Bank of America Merrill Lynch's Savita Subramanian wrote. 'We assume an investor sells after a 2% down-day and buys back 20 trading days later, provided the market is flat or up at the end of that period.'

Can you guess what happened?

'This strategy underperforms the market on a cumulative basis since 1960 both overall and during every decade, given the best days typically follow the worst days.'

See also: 'If you missed the rally, then you probably just made the most classic mistake in investing'

And: 'Here's the smartest way to invest in stocks if you're convinced the market will keep crashing'

Stocks will go down a lot, but then they will go up a lot more.

BAML

Bank of America Merrill Lynch's Subramanian shared a chart that does a nice job of illustrating the roller-coaster ride that stock market investors actually experience.

She reviewed 12 major S&P 500 peaks since 1930 and averaged the price performance during the months leading into the peak and the months after.

To be clear, this is just a summary of what has happened in the past around market peaks. In between these events are long periods of lacklustre action in the markets. Having said that, there are a couple of things to take away from Subramanian's research:

  • Returns are very strong in the months leading up to a peak. The median returns in during the six months and 12 months before a peak were 14% and 21%, respectively. An investor seeking gains probably wants to be part of that action.
  • Declines after a peak are bad, but they don't offset the gains. The median returns in during the six months and 12 months after a peak were -12% and -15%, respectively.
  • But even after the violent sell-offs, markets recover losses in two years. The median return 24 months after a peak is -1%, meaning that most of the losses seen in the six-month and 12-month periods are recovered for patient investors. If anything, downturns are opportunities for investors to buy more and lower their average costs.

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