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S&P 500 impressive gains may be too impressive

In this blog we look at rolling 12-month returns for the S&P 500 total return index and ponder whether the market is due for another relatively large pullback. Looking at rolling 12-month returns instead of the industry norm of annual returns gives us a lot more data points for any study. So instead of calculating annual returns from 1988 to 2024 which would give 36 or so data points, we look at every month in the series and take the percentage gains from 12-months in the past – giving around 430 data points!


I am comfortable with using the data in order to calculate average expected returns, as any retail investor or wealth manager who deals with investors will know that not everyone puts money to work on the first of January in order to calculate their gains at the end of the year. Investors putting money to work in the S&P 500 (and other markets) at any point in the year will want to know what they should expect to make over the next 12-months. The easy answer is to say that we don’t know. But on average, going back to January 1988 (the start of the data series) and including dividends, the rolling 12-month return is around 12.3% (table below), which gives an estimate which may help in anchoring expectations. The extreme range of returns (on a 12-month monthly close basis) is a potential 56.3% gain, or a -43.3% loss, which gives the historical outliers which won’t help investor expectations, but is a dose of reality!


A note of caution is warranted for this study as John Calverley, Tricio’s Chief Economist, points out that PE ratios have more than doubled since 1988 and may not do the same in the future. His long-term (since 1900) estimate for real returns in the US stock market is 6%-7% per year (8%-9% nominal returns if inflation is 2%), which suggests that expecting 12.3% on a 12-month return would be ambitious.



This is a very broad range of historical returns, as the scatter chart below shows.



A more useful chart would be the distribution chart below. There are some ‘fat tails’ in this chart but it underscores that for the most part, investors have enjoyed returns between 1% and 31% (red circle).



What if we project the expected returns of 12.3% into the future on a 12-month rolling basis? The chart below does just that. The blue line is historical data, the red line is the projected 12-month expected return, or where the S&P total return index should be in 12 months if it gained 12.3%. Too simple? Yes. Helpful? Maybe…



The chart below shows the same two data series with the forecast error in grey. This is simply the blue line data point less the red line data point at the same point in time. In other words, did the S&P 500 total return index match the rolling 12.3% expected 12-month return. If it exceeded it, the grey line is positive, if the return was less than the expected return, the grey line will be negative.



We can also do the same plots on semi-log data in order to try to focus on the real percentage returns and to account for the effects of the long-term rise in the S&P 500 total return index (semi-log chart below).



The same semi-log chart with the forecast error line (grey) is shown below. Again, if the grey line is positive, the S&P 500 total return index is showing higher returns than forecast. This is not necessarily a bad thing of course. But, the thing about doing better than average, is that a return to the average line is something that can happen. Either the underlying index stalls a bit and the forecast returns ‘catch up’ or the underlying index falls and gives us the ‘mean reversion’ that stock market fund managers are familiar with.



After looking at the data tables and charts, the mean reversion aspect of stock market returns is perhaps the bottom line ‘takeaway’. The US stock market has had a heck of a good run for some time, and the boost since bottoming out in 2022 has seen the S&P 500 total return index (blue line, chart above) well above the expected returns (red line). This is simple math so it has to happen every now and then. In general though, when it does happen for a while, the blue line seems to eventually dip below the red line. Dot-com bubble, housing bubble, post-Covid bounce retrenchment…


Or this could be the ‘irrational exuberance’ part of the cycle similar to the 1994-2000 run that prompted Fed Chair Greenspan to make his famous observation at the time. Plenty to ponder!

 

 

Gerry Celaya

Chief Strategist

 

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