Charts of the Month - December

The Year After a Strong Year

The days go by slow, the years go by fast, and change happens quickly.

Stating the obvious: A lot changed from 2022 to 2023—equities flourished, bonds bounced back, and inflation dialed down.

But that’s the past, and markets care about the future.

The question we should be asking: What happens to equity markets after strong years?

Isolating years where the market returns more than 20%—like last year—there have been 20 instances of that happening since 1970.

What happened the following year? The market was positive in 13 of the 19 years, or nearly 70% of the time.

And the market was up more than double digits in 11 of those 13 years in which it was positive!

Does this data signal smooth sailing from here? Of course not, no such signal exists. But at the very least—it does help long-term investors shape a mental model of what could lie ahead.

The biggest takeaway is a good year in markets does not indicate that a bad year must follow.

Strong periods won’t last forever, but we should also remember that good years tend to come in clusters, and these periods can often last longer than we think.

Funny Truth About Averages

The S&P 500 has returned nearly 11% annually since 1970. But how often does the market return 11% in a calendar year?

Almost never. Since 1970, it’s only happened once.

That’s the funny truth about average market returns; we don’t see them very often.

Pulling the data since 1970, the stats read:

• 1 year with an annual average return of 11%

• 31 years of returns 12% or greater

• 22 years of returns 10% or less

The historical evidence—more than 50 years’ worth—tells us it’s significantly more likely the market will return more than 20%, than it will return the historical average. However, the same is true for negative returns. 

That’s the nature of averages, they split the difference between big numbers and small numbers.

Tale of Two Markets

The S&P 500 was up 27% last year, but 72% of the stocks inside the index returned less than that.

The funny truth about averages strikes again!

The reason for this result is obvious—the market was top-heavy and dominated by a select few mega-cap companies, notably the Magnificent 7. This is a topic we’ve litigated in great detail previously.

But an interesting fact? Size can often be a major detriment to future returns.

Using data from Dimensional Advisors, the strongest period of returns for the top 10 stocks by market cap tends to happen before they become the largest stocks in the market. This isn’t exactly profound—the only way a stock gets into the top 10 is through extreme outperformance, obviously.

But what happens after a stock breaks into the top 10?

Nearly 100 years of data shows that leading stocks—once established in the top 10—tend to lag the market. 

This data brings Howard Marks concept of second-level thinking to mind. Second-level thinking goes beyond the first level, which is simplistic and consensus driven.

For example, “Tesla is dominating!” might be an example of first-level thinking. Everyone knows Tesla is dominating. It’s been one of the best-performing stocks for a decade and in the news regularly.

Second-level thinking might say, “Everyone knows Tesla is dominating. The stock is priced like it’s going to own the majority position in the auto sector for the next few decades and succeed entering into new businesses as well.”

To be clear, we’re only using Tesla as an example and not wagering a specific opinion on its future.

But this type of deep thinking and analysis can sometimes go missing when companies enter top 10 status, as the data above outlines. It’s a cautionary tale to some extent, investors suspend belief and believe outperformance can last forever.

But it’s not true. Though, we admit we can never say when outperformance will stop with precision.

The remedy to this likely comes in the form of diversification.

At a high level, there seems to be two parts of the U.S. large-cap market:

1) The higher valuation (expensive) part that is driving most of the performance and headlines.

2) The lower valuation (cheaper) part that feels largely ignored.

A simple thought exercise would be peeling back the layers on the S&P 500. For example, the S&P 500 trades at nearly 20 times earnings, which is the high end of its historical valuation range.

But if you isolate value stocks inside the index, much cheaper valuations can be accessed. For example, the price-to-earnings ratio of the top 10 holdings in the large-cap value index is 14.6.

There are opportunities to be found if you go deep enough.

In fact, rather than chasing the Magnificent 7, investors might be well served to ensure their portfolios are broadly diversified to potentially capture the returns of companies that might be ascending in the future.

One area we might call out: dividend payers.

Zooming In on Dividend Payers

The dominant theme that held court last year? Artificial intelligence, or AI.

AI helped propel technology stocks to podium position, finishing up 56% for the year, while contributing most of the market’s gains.

But as Newton's third law states, “Every action has an equal and opposite reaction.”

While AI-adjacent companies rocketed higher, valuations for dividend-paying companies quietly fell to multi-decade lows relative to the S&P 500.

There seems to be two obvious benefits for dividend-paying stocks in the current environment:

1) Access to a cheaper pockets of the market.

2) Diversification away from Big Tech.

But there’s also a third benefit that might be the most interesting:

3) Potential for consistent and growing income at a time when rates are falling.

The 10-year Treasury fell more than 100 basis points from mid-October through Dec. 29.

Why? It’s possible that the market is front-running the consensus expectation that the Fed will begin cutting rates as early as March. This is particularly interesting given that money market funds became one of the hottest asset classes for dollar flows last year, as rates jumped above 5%.

But the market seems to be indicating those money market rates weren’t permanent.

Contrast that with dividend-paying companies, using Waste Management as an example. It raised its dividend 7% in December, making it 20 consecutive years with a dividend increase. Emphasizing consistent and growing income might be better than chasing yield.

It’s hard to know when the proverbial music will stop playing in hot areas of the market, but dividend-paying companies could be a worthwhile objective to emphasize in portfolios.

Volatility Rebound

Uncertainty is always high in markets, but sometimes fear isn’t.

The VIX, or “fear index,” reflected that last year was the least volatile year for U.S. equities since 2019.

Since 1990, the average reading on the VIX has been 20. Last year, it was 16.8.

There are reasons this year may not be as calm. One that is notable? The election cycle.

There will be 77 elections worldwide this year. Per Barron’s:

“50% of the world’s population will go to the polls in 2024. Some of these elections aren’t getting much attention. We have elections in Taiwan in January, and Indian elections in April and May, which could make a difference in markets.”

The elections most people care most about are the one’s close to home. We have a presidential election in the U.S. this coming November.

Analyzing returns data from past 10 U.S. presidential election cycles, you can see that Q1 tends to be the weakest quarter of the year—down approximately 1% on average—but the rest of year is usually fine, with positive returns on average.

An easy prediction? Political volatility will be through the roof—we can feel certain about that.

But for markets, we should keep in mind that politics and investing go together like oil and water. Investors will be best served to have a plan in place and stick to it.

The election cycle could reintroduce more volatility, but that also could come with potential opportunity.