Financial experts often refer to historical stock market returns to set investor expectations. Since 1926, the S&P 500 has annualized 9.8% returns. Of course, in any given year, the returns are often much higher or much lower. The big swings in market returns often have to do with whether or not the US Economy is in a recession. We examine the last 50 years of market data and our Business Cycle Indicator to see just how much returns can differ. The chart below shows the last 20 years of the S&P 500 and illustrates the impact of recessions. The two significant market declines, 2000-2002 and 2008, both occurred because of recessions.
At the beginning of 1968, the S&P 500 index stood at just 96.47. Fast forward to 2017, the S&P 500 finished last year at 2695.79. It was no doubt an amazing run over those 50 years. The index (excluding dividends) increased in value by nearly 2,700%. But as the chart above illustrates, the market did not go up in a straight line.
Market History and our Business Cycle Indicator
Using the same historical data we look at how the stock market performed when our Business Cycle Indicator was either warning of a recession or not. Our Business Cycle Indicator (BCI) is designed to provide an early warning of an recession in the US Economy. The table below provides a breakdown of the historical returns.
Over the last 50 years, our Business Cycle Indicator (BCI) was warning of a recession about one-third of the time. During those 199 months, the S&P 500 lost 19.6% of its value. Taken together, it is more than 16 years of being invested in the stock market with nothing but a loss to show for it. The reason for those losses is that during those 199 months the US economy experiences seven recessions. As one would expect, the stock market declined during these periods. Much like the first chart illustrates during the last two recessions.
On the other hand, 67% of the time the our BCI was not warning of a recession and coincided with very strong returns for the stock market. More than 125% of all the gains over the last 50-years occurred while BCI was was not warning of a recession. This analysis doesn’t include dividends, and it also assumes no returns for the 199 months that there is a warning of a recession.
Below, we run the same analysis using the S&P 500 Total Return Index, which includes dividends. The data for this index goes back to 1988 so we have 30 years of historical data as opposed to 50 years we used above. The results are better due to the inclusion of dividends and the fact that there were only three recessions during this period. Importantly, our BCI still shows its ability to improve investor results by avoiding losses caused by recessions. More than 150% of all the gains over the last 30-years occurred while BCI was not warning of a recession.
The results above still leave out one important point. For those periods when our Business Cycle Indicator warns of a recession, we assume no returns during those months. So while the market returned 16.2% annualized, it leaves out any return for the 88 months when the warning is active. Naturally, the portfolio would not sit in cash earning nothing. At a minimum it would be investing in some interest bearing investment. Because of this, the table above is actually understating the returns that are achievable with this research.
Our CycleWise Portfolios use our Business Cycle Indicator to move client portfolios from a balance asset allocation and into bonds. Bonds typically rise in value during a recession because investors are looking for safety. When the stock market is in free-fall, investors put their money with the one entity those know will survive – the US Government. During each of the last two recessions, our model portfolios were up more than 20%. Keep in mind, these were both periods where the stock market lost about half of its value.
Lowering Future Expectations (or not)
Earlier this year, Morningstar Research put together an article with various market experts and their muted expectations for stocks over the next 10 years. On the surface, their logic makes sense. The market has had a great run over the last 9 years. It can’t go on forever.
These muted returns could in fact turn into reality. However, it’s not likely that the market will simply moving sideways. There will continue to be big ups and downs over the next 10 years. When the stock market suffers a really big loss, it’s often due to a recession. We haven’t had a recession for nine years, so these forward estimates likely take into account one happening fairly soon. Due to the fact that our Business Cycle Indicator would have predicted each of the last seven recessions, we are confident that investors can do far better.
It is extremely important for investors to have a process to protect their investments from recessions. We outline why here: How Much Could You Lose During the Next Recession? If they do not, the modest returns displayed above may be all they get from their equity investments over the next decade. This would no doubt have an impact on an investors overall financial well-being.
How Much of an Impact?
On a $100,000 investment over 10 years, the difference between Schwab’s 6.7% expected return (the most optimistic) and 16.2% (S&P Total Return without a recession warning) is a staggering $257,539.88. Disclosure – we aren’t suggesting that investors should expect 16.2% from their investments. We are using this example to demonstrate the power of compounding returns.
Our process provides investors access to financial markets when times are good while providing protection from recessions. The goal is to deliver better results so they have the financial resources to live life to the fullest.
Backtesting involves a hypothetical reconstruction, based on past market data, of what the performance of a particular account would have been had the adviser been managing the account using a specific investment strategy. Performance results presented do not represent actual trading using client assets but were achieved through retroactive application of a model that was designed with the benefit of hindsight. Backtested performance results have inherent limitations, particularly the fact that these results do not represent actual trading and may not reflect the impact that material economic and market factors might have placed on the adviser’s decision-making if the adviser were actually managing the client’s money.