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5/14/2013

Normal volatility?  When is the next "crash"?

The equity markets continue to move upward at a pretty exciting clip this week.  Using the S&P 500 as a proxy for the overall market, current levels are more than 20% higher than one year ago:
^SPX Chart

^SPX data by YCharts

20% seems like a big number, right?  I was curious how many times the S&P 500 had shown year over year gains of 20% or more, and so I did a little home work.  With an historical data file download for the index from Yahoo's Finance page, I pulled out the price of the index on the first market day in January for each year going back to 1950.  Using this subset of data and a simple spreadsheet calculation, I found that the S&P 500 had gained (from one January to the next) 20% or more 12 different times.  That's 12 times in 63 years.  If you loosen up the criteria a little to 10%, the number jumps to 32 times the index gained at least that amount in a year over the 63 years studied.

Of course, that means that there were many years that came in at less than 20% or even 10%.  Using only this January data, there were 47 years with a positive return of any amount, meaning there were 31 years with some gain but less than 10%.  And then there are the years with no gain or even a loss.

The worst yearly return for the data in this study was for the period between January 2008 and Jan 2009...
^SPX Chart

^SPX data by YCharts

A year over year loss of 37.58%!  (in the Yahoo data, they show a number more like -40%).  But how common are double digit losses?  Diving back into the data, it looks like there were 3 instances of a year over year decline of 20% or more, and 7 instances of a 10% or greater fall.

What can we take away from this data?  There are a few concepts I would like to highlight:
  • The markets are volatile.  While +/- 10% moves represent enormous swings in value, they occur with regularity.  Taken together, the years with 10% or higher gains and 10% and lower losses add up to 39 years out of 63 in the given study.
  • Reducing 60+ years of data to only January prints may actually undersell the issue.  There is considerable volatility within a given calendar year that doesn't necessarily show up in the Jan to Jan data points.  For instance, within 2011 there was a wild variety of experience: From January to December, the S&P fell 1.1% on net, but from July to August fell ~ 11% and from September to October gained 16.7%!  The point here is that the experience of holding the index through these periods can feel quite volatile, regardless of the calendar year returns.
  • Taking a simple average of the January to January data for 1950 to 2013 gives approximately 8.5%.  This is the kind of number often discussed in the press and financial literature, suggesting that someone with the capacity to buy and hold the index over a very many years would see their realized return shake out to a considerably positive number that bears little relation to the extremes of any one year.
  • The past does not predict the future, and investors must thoroughly consider their own situation before making a decision on risk and acceptable volatility.  Too often people overlook the natural cycle of life, along with the related things that come up as we age and our circumstances change. Will there be another 10 - 20% drop in the S&P 500 in the coming years?  Almost certainly, the answer is yes.  But when will it come and what will the recovery look like is far less certain.

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    Author

    David R Wattenbarger, president of DRW Financial

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