Investors: Enjoy Above-Average Stock Market Strength While It Lasts …

Investors: Enjoy Above-Average Stock Market Strength While It Lasts …

They tell me a revival is only temporary; so is a bath, but it does you good.
— Billy Sunday

As we continue along in November, the S&P 500 (INDEXSP:.INX) is off to its best start since 1997, up over 23% YTD. Two questions are on the minds of most investors: (1) Is further upside likely into year-end, and (2) are the best returns behind us?

On the question of year-end strength, there are a few factors working in favor of the bulls. On a seasonal basis, November and December are typically strong, with an average cumulative performance of +2.1% since 1928 and 68% of years posting positive returns.

Additionally, when the S&P has been as strong as it has been this year, the year-end returns tend to improve. For example, in years where the S&P was up over 15% through October, the average November-December performance jumped to +4.8% with 83% of years posting a positive return. Contrast this with years in which the S&P was down through October. In those years, the average return into year-end was a negative -1.5% with only 48% of years posting positive results.

Importantly, the risk of a downside correction into year-end also decreases when the stock market is strong through October. In years where the S&P was up over 15%, the worst year-end performance was a decline of -2% in 1943. Conversely, in years where the S&P was down heading into November, the worst year-end performance was a -22% decline in 1931. Of course, as I’ve been noting all year, 2013 has been highly unusual given the massive disconnect between the stock market and reflation expectations, which might make this type of historical analysis not as appropriate this time around.

Next, on the question of whether the best returns are likely behind us, there a few factors suggesting that this could be the case regardless of reflation. Given the strong year-to-date gains and the unusually smooth trajectory of these gains (only one correction of greater than 5%), investors have naturally become more complacent. The recent Investors Intelligence poll showed 52% bulls and 16% bears. The spread between bulls and bears of 36% is in the 92nd percentile of historical data points.

In the past, when the bull-bear spread has moved above 30%, we have seen below average subsequent returns on average. In the first chart below, you can see the general decline in returns as sentiment moves from bearish to bullish extremes. In the second chart below, the inverse correlation between sentiment and forward returns is evident, as the average returns following periods of high bullishness are below average in all subsequent periods.

In terms of calendar year returns, if the S&P 500 holds its strong gains into year-end, is there anything to suggest one should expect similar gains in 2014? To the contrary, in the years in which the S&P has returned greater than 15%, the return the following year was below average. The best performance on average followed years in which the S&P 500 was down.

Overall, the odds favor continued strength into year-end given favorable seasonality and strong YTD momentum, but this of course assumes that the stock market will continue to ignore the reflation disconnect. However, investors should be enjoying this above-average strength while it lasts. Given the current sentiment data, most investors are already bullish on the future prospects for the equity market. In the past, this has generally led to below-average returns going forward. Additionally, investors should not be simply extrapolating 2013 performance into 2014 as returns in years following high returns (>15%) have actually been below average.

Twitter: @pensionpartners

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Investors: Enjoy Above-Average Stock Market Strength While It Lasts …

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