Last week we provided readers with our Top 5 Predictions for 2020, which provides a view of our current thinking on what we consider the most probable outcomes for the new year. If you missed it, or haven’t yet gotten the chance to read it, here’s the link. In this week’s edition of Week on Wall Street, we’ll focus our attention on the upcoming election, and look back at market history to provide some background on our base rates (ie what is typical) to help frame expectations. The 2020 election is likely to prove to be anything but typical, but there are insights to be gleaned from market history. The key takeaway is that while election years tend to provide solid returns, investors should expect a bumpy ride!
Let’s first set the table with a baseline expectation of what stocks may do in the year ahead. To do so, we consult our favorite investment resource, Mr. Market. The market data set we use goes back to 1928 and what we find is that the average annual return for the S&P 500 index from 1928 to 2019 is 11.6% including dividends. That’s our starting point. In the 23 election years in the data set, the market averaged an annual return of 11.1% — so, basically average. In 19 years out of the 23, (83% of the time) markets were positive, and consequently, 4 years (17% of the time) had negative returns. Of those 4 years with negative returns, 2 of those were in recession, 1932 and 2008. The other negative return years were 1940 (World War 2) and 2000 (Dot Com bubble burst). What a cursory analysis of this data tells us is that as long as a recession, catastrophic war, or bursting of an investment bubble can be avoided, the probability of a year of solid returns could be likely. It’s important to note that our conversation today does not account for differences in valuations and interest rates, which are certainly important. In a nutshell, interest rates are low, which is supportive of returns, but valuations are high which may contain returns. It is for these reasons, among others, that our forecast for U.S. stock returns is mid-single digits for 2020.
If looking at the annual returns during election years gives rise to warm and fuzzy feelings, a deeper dive into the specifics encourages some caution. While overall returns in election years are largely positive, they are not without considerable volatility. The table below highlights both annual returns in election years going back to 1952, and also the annual maximum drawdown, (percentage loss from peak to trough) rounded to the nearest whole percent. For example, say the market returned 10% in a given year, after first rising 20%, before correcting 10%.1 The 10% drop, from up 20% to up 10% is the max drawdown. No one likes drawdowns, but they are a part of the game. The average annual return for this data set is 10%, but the average max drawdown is 11%.
This tells us that while more times than not, election years are good for markets, especially if catastrophes are avoided, the way we earn the returns is typically not straightforward. There are, however, some important caveats. First, this table highlights the maximum drawdown for each year, but there are some years that experience multiple drawdowns of greater than 5%. Second, the average drawdown of 11% is disproportionately affected by 2008; using the median drawdown of 8% provides a more typical experience. Lastly, in every year save 1964, the market experienced a drawdown of at least 5%. (Fun fact: 1964 was the first election after President Johnson took office following the assassination of President Kennedy in 1963). This more nuanced look at the data lends credence to our view for positive, yet volatile returns in 2020.
We’ll take this opportunity to remind readers that in markets anything can happen. There is a first time for everything, but we hope that this article serves as an example to our readers of how we think, and how we conduct our investment process. We use history as a guide, account for the current specific environment and focus on probabilities to give both our predictions and our portfolios better chances for success.
- A 20% rise followed by a 10% drop would actually produce a return of 8%. (1.2 X 0.9) The point was to explain drawdown so please forgive the lack of precision in the math.
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