Tuesday, August 16, 2022
HomeWealth ManagementThe Stock Market's Rebound Has History on Its Side

The Stock Market’s Rebound Has History on Its Side


(Bloomberg Opinion) — The benchmark S&P 500 Index’s recent rebound has brought it more than halfway back from its 2022 low point in mid-June, which is an encouraging sign for many investors. It’s certainly one of the most statistically reliable signals in the stock market. But does that mean it’s safe to get back into stocks?

Since 1926, stocks have recovered more than half of a 10% or larger decline 79 times and only once, in March 1930, did the market reach a new low before setting a new all-time peak. Moreover, the average return in the month after the 50% point is reached is 2.7%, better than the 0.9% average for all months. The year after averages 16.0% versus 12.7% for all years. Volatility is lower than average after the 50% point as well.

Remember that past performance is not indicative of future results. And we know the stock market is pretty close to a random walk, so making investment decisions based on patterns in charts is a risky game. On the other hand, strong statistical patterns in securities returns are the main way we learn about markets. And we can tell a plausible story about this pattern. Something bad happens and stocks fall. The drop scares a lot of people who flee the market. It exposes weak hands who are forced to sell, or even to go bankrupt and dump their assets. Few new investors are brave enough to buy stocks. For these reasons stocks fall more than the fundamental news justifies and stay down longer.

By the time the accumulation of good news has erased half the losses, laboring under the drag of investor pessimism, we’ve likely put the bad behind us and are on a new upswing. But prices are still lower than they should be due to fearful investors. We can expect the old investors will start returning to stocks, new investors will enter and optimists will increase their leverage. As the headwind changes to a tailwind, stocks should do better than average for a while. The bravest investors “buy when there is blood in the streets.” This is not quite so bold: “Buy when half the blood has washed away, but the most people are still cowering at home.” If you wait until the streets are scrubbed clean, you have to expect to pay top dollar.

We can get a more precise picture by looking at the performance of equity factors the previous 79 times the market made it halfway back from a 10% or greater decline. The oldest and best-documented equity factor is size, with small stocks having outperformed large stocks by about 1.5% per year on a risk-adjusted basis. This is generally seen as a reward for seeking out more obscure, less liquid securities with less information available and sparser analyst coverage, some of which are too small for big institutions to bother with. In the month following 50% recoveries, small stocks have beaten large ones by 1.9%, and over the year following by 3.6%, both figures much larger than the normal 0.1% to 1.5% outperformance.

Another popular factor is value, or stocks with low prices relative to fundamental measures such as book value. Picking value stocks generally rewards investors with a 4.3% annual advantage over higher-priced stocks. Value does about average in the month after a 50% recovery, a 0.4% advantage versus 0.5% over all months, but disappears in the year after a recovery, providing a 0.1% advantage versus an average 4.3% over all months. So, the halfway point of the recovery is too late to beat the value investors as all the Warren Buffetts have already bought up all the great values. You have to go to the smaller and more obscure stocks for maximum exploitation of the situation.

How about the momentum factor? This consists of buying stocks that are going up and shorting stocks that are going down. Momentum is actually a negative after 50% recoveries. It costs you 1.9% in the month after a 50% recovery and 0.3% in the year after, versus average gains of 0.6% per month and 7.2% per year in normal times. Getting in because the market’s going up is a momentum play in timing, but history argues you should not double up by picking the stocks going up the fastest. Look instead to anti-momentum stock selection, buying the stocks that are still going down, or at least have not gone up as much as the others.

None of this is investment advice. Buy your own stocks — or not — for your own reasons, and take your gains or losses as they come. But when commonsense stories are consistent with statistical patterns in the past, perhaps you can invest with slightly more confidence than usual.

More From Other Writers at Bloomberg Opinion:

Fed Needs to Resist Opting for Quick and Easy: Mohamed El-Erian

‘The End of the Beginning’ of the War on Inflation: John Authers

Don’t Buy the Stock Rally? The Smart Money Does: Robert Burgess

 

To contact the author of this story:

Aaron Brown at [email protected]

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