Market history favors stock investors every year
There is precisely at 65.5% chance that U.S. stocks will be higher one year from today. Many investors will be happy with those odds, given that the stock market has been unexpectedly strong so far this year. But what they might not realize is that the odds of an “up” market in 2018 would be the same even if equities had been terrible performers this year.
In fact, the odds of a positive year are the same regardless of the conditions that prevailed in the previous calendar year.
That at least is what I found upon feeding into my PC’s statistical package the yearly returns for the Dow Jones Industrial Average DJIA, +0.29% since it was created in 1896. Of the 119 calendar years since then, the stock market has risen 78 times — or 65.5% of the time, on average. Following calendar years in which the stock market rose, in the next calendar year it rose in a statistically equivalent 65.4% of the time.
And, as you can see from the chart below, these are exactly the same odds that apply following years in which the Dow fell.
Why are the stock market’s odds of rising so impervious to what happened in the previous year? Actually, it would be surprising if this weren’t the case, according to Lawrence Tint, a chairman of Quantal International, a firm that conducts risk modeling for institutional investors. In an interview, he argued that what emerges from the data is exactly what we should expect from an efficient market — a market whose level at any given time reflects what is already known and therefore has incorporated past history.
If, instead, the stock market’s future direction was a function of what had come before, Tint continued, it would suffer from “unnecessary and unhealthy turmoil. We can be comforted by the fact that reasonably efficient markets always base their level on anticipated future returns, and do not include history in the calculation.”
This is particularly illustrated by the right-most bar in the chart, which reflects the market’s historical odds following years in which stocks gained more than 20%. That’s relevant to today’s situation, since the Dow’s year-to-date gain is around 22%. As you can see, however, the odds of the market rising in the years subsequent to such gains are no higher or lower than in any other year.
A good way to understand these results is to think of coin flipping: What are your odds of flipping a heads after flipping, say, five heads in a row? Those odds are no different than if you had flipped five tails in a row, of course. To think otherwise is to be guilty of what is known as the “gamblers’ fallacy.”
This isn’t to say that the stock market and coin flipping are equivalent. But playing the stock market over the short term is essentially gambling. It’s only over many years that considerations like valuation start to play a statistically significant role.
The bottom line? Optimists will latch on to the two-out-of-three odds of the market rising next year, and pessimists will focus on the one-out-of-three odds of its falling. Regardless of what does happen, the outcome will have nothing to do with how well stocks have performed this year.