Is the Past Prologue? Fisher Investments Reviews Market History

When things go right, how often do you presume it is only a matter of time before the fun ends? Or during tough times think, “They can only get worse”? Optimists might think something good has to happen—it is due. Whether in everyday life or market activity, these sentiments are common. Fisher Investments finds people tend to both extrapolate the recent past forward and presume the law of averages will take hold, pulling reality toward the long-term mean. Even though most financial literature stresses past performance doesn’t predict future returns, investors often presume it does—even without realizing it. Let us explore this pitfall and how to spot it.

In Fisher Investments’ experience, investors don’t consciously believe past performance predicts. But that fallacy underlies a number of common assumptions. When markets are bad, many presume downturns will continue. Similarly, throughout market history, observers fall into euphoric patches, believing this time is different and markets can’t fail. People also often think averages—created by past returns—are predictive. We see this frequently in statements like, “Stocks are due for a recovery.” We also see this in Fisher Investments’ reviews of professional forecasts, which often project sagging returns after very good years. All seemingly rest on the assumption the S&P 500’s long-term average of around 10% annualized has a gravitational force.[i] The same thinking often applies to price-to-earnings ratios—pundits frequently argue valuations must revert to their historical mean, taking stocks lower or higher as they do.

This year is no different. As we passed the June 30 halfway point, pundits observed that S&P 500 returns in 2022’s first half were the worst since 1962. Some argued this augurs poorly for the second half. Others argued a recovery must be imminent simply because bad first halves have preceded good second halves. However, coincidence isn’t causality. A broader look at the data shows first halves don’t predict second halves. The correlation coefficient between first- and second-half returns dating back to 1925—when good S&P data begin—is -0.099%.[ii] A correlation coefficient—ranging from 1.0 to -1.0—measures the relationship between two variables. A 1.0 coefficient means they always move together, zero means there is no relationship and -1.0 means they always move in opposite directions. While the -0.099% correlation means first- and second-half returns moved in opposite directions slightly more often than not, it is functionally meaningless.

According to Fisher Investments’ review of historical data, returns aren’t serially correlated over any time period you choose—meaning, one period doesn’t predict the next. Take S&P 500 year-to-year returns. The correlation coefficient between one year’s returns and the next is -0.008—basically zero.[iii] As the exhibit below shows, of the 26 down years, the next year was up 17 times and down 9. So, does this mean down years predict up years? No, it just means stocks rise the majority of the time, and a year is often a long-enough stretch to even out very short-term wobbles. Case in point: Of the 71 up years, the next year was up 53 times and down 18.

Shorter time periods show more randomness. Monthly returns have an ever-so-slightly positive correlation of 0.077—still insignificant—with returns after positive months up 64.5% of the time and down 35.5%.[iv] After down months, returns were positive 60.57% of the time and down 39.3%. Weekly and daily returns—with 0.004 and 0.000 correlations, respectively—were even more scattershot.

Exhibit: Are Past Returns Predictive?

Source: Global Financial Data and FactSet, as of 07/12/2022. S&P 500 Total Return Index, 12/31/1925–12/31/2021, and S&P 500 Price Index, 01/01/1928–07/05/2022. Monthly and yearly data use total returns; daily and weekly data use price returns.

Stocks are forward looking—moving on the gap between expectations and reality. They focus on whether economic fundamentals look likely to keep corporate profits generally better or worse than expected over the next 3–30 months. That is a function of conditions in the future—not what market performance was over the past day, week, month or year.

So, Fisher Investments’ take on this: Don’t extrapolate recent experience forward. We know downturns like 2022’s first half feel scary and can heighten the urge to avoid stocks. However, acting on these impulses can sideline you during some very good times when markets rebound. So think like stocks and look forward, not backward, and don’t let recent performance cloud your judgment.

Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns. Investing in foreign stock markets involves additional risks, such as the risk of currency fluctuations. The foregoing constitutes the general views of Fisher Investments and should not be regarded as personalized investment advice or a reflection of the performance of Fisher Investments or its clients. Nothing herein is intended to be a recommendation or a forecast of market conditions. Rather it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated herein. Not all past forecasts were, nor future forecasts may be, as accurate as those predicted herein.

[i] Source: Global Financial Data, Inc., as of 12/31/2021.
[ii] Source: Global Financial Data, Inc., as of 07/15/2022.
[iii] Ibid.
[iv] Ibid.

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