Is History Irrelevant?

09 Dec Is History Irrelevant?

• The S&P 500 monthly returns have been persistently positive with increases in 8 of 10 months, on average. This is highest ratio since 1998.

• The index is on pace to generate the 2^nd best annual return since the financial crisis on relatively low volatility.

• After periods of persistently positive returns, volatility increases despite positive returns tending to persist.

The U.S. equity market is generating positive returns.  The S&P 500 has increased 25.3% year-to-date on the back of a 3.4% increase in November.  The most recent 3-year period has provided positive monthly returns 80% of the time.  This matches the highest level measured since 1975.  December 1997 through April 1998 is the only other time that this has occurred.

Can the experience in 1997-1998 guide expectations for return and volatility?  If so, positive monthly returns are likely to persist and volatility will increase.

Return Expectations

A return persistence measure applied to the U.S. equity market is informative.  Some institutional investors observe the frequency of a manager’s positive returns to determine the durability of an investment strategy and process.  One persistence measure is the ratio of positive months to total months for a performance period.  The S&P 500 is currently at 81.1% with a 20% chance of maintaining or exceeding the current level.  The current level is above the index’s 61.4% average based on data from 1975 to present.

The S&P 500 has been here before.  In December 1997, the S&P 500 reached 81.1% and maintained this level for 5 months before declining slowly to 37.8% in July 2002.

The distribution of performance persistence measure has remained fairly symmetric and the mean has changed little since the financial crisis of 2007 – 2008.

Average = 61.4%   Observations = 504

Average = 60.5%   Observations = 373

Average = 63.9%   Observations = 131

A couple of the influential sectors within the index have behaved differently.  The distributions for the index’s 2 largest sectors, technology and healthcare, by market capitalization weight have shown increases in the average of the performance persistence measure.  Technology has become less skewed with more persistently positive performance.

Average = 50.3%   Observations = 85

Average = 62.7%   Observations = 131

The healthcare distribution has remained fairly symmetric and the average performance persistence increased.

Average = 53.5%   Observations = 85

Average = 68.1%   Observations = 131

The increase in performance persistence at the sector-level is clear.  But, performance persistence does not say much about the magnitude of performance.  The S&P 500, technology, and healthcare had mixed performance subsequent to the December 1997 maximum.  The index was positive for the 1- and 3-year periods.  The technology sector was negative for the 3- and 5-year periods.  Healthcare was positive, but declining for all periods.

A larger window for determining positive performance persistence offers different results.  A 60-month window indicates that the S&P 500 has not reached its maximum of 76.7% which occurred previously in June 1999.  The returns after June 1999 tended to be negative.

The larger window may be a better indicator of future performance.  Regardless of the window size, there is a clear relationship between the positive performance persistence measure and volatility.

Volatility Expectations

Volatility will likely trend up.  There is an inverse relationship between volatility and the performance persistence measure regardless of the index, sector, or measurement window.  The volatility trend tends to reverse within several months of the performance persistence measure registering a trend maximum or minimum.  This result is intuitive because a reduction (increase) in the persistence measure requires more negative (positive) monthly returns.

Financial crisis demarcation date is December 2008.

Conclusion

The U.S. market has consistently produced positive monthly returns.  The likelihood of the S&P 500 continuing to produce consistent positive monthly returns is a coin toss.  The magnitude of returns for the next 12 months is likely to be lower than the YTD return.  The consistent positive performance at its previous peak in 1997 – 1998 persisted for 5 months before declining.  Given the current monetary and geopolitical climate, a 5-month holding pattern could be a low estimate.

Methodology:  The U.S. equity market, technology sector, and healthcare sectors are proxied by the S&P 500, XLK ETF, and XLV ETF, respectively.  The S&P 500 time series starts January 1975 and ends November 2019.  The XLK and XLV series begin January 1999 and end November 2019.  The performance persistence measure is the number of monthly returns greater than 0 divided by the previous 36 months, inclusive.  The measures are calculated monthly starting December 1977 for the S&P 500 and December 2001 for XLK and XLV.

 Addendum:  The 20% chance of meeting or exceeding the current performance persistence measure assumes a lookback to 1975.  If the lookback is to the financial crisis, the probability increases to 76%.