2017 was one of the least volatile years in US stock market history, with most major indices enjoying 20% or more in positive returns. What might that tell us about the coming year?
Volatility Is Normal — Low Volatility Is Not
Take a look at the chart below, which shows historic “low volatility” years of the S&P 500 from 1945 through 2017. “Volatility" here is defined by the number of trading days that markets moved either up or down by 1% or more. As you can see, on average, the least volatile years tend to have an average of 20 days of such volatility, meager 4% corrections, and then huge annual returns of 25%.
Looking at 2017, you can see that it had only 8 days of “volatility,” 60% less than the average for low volatility years.
"The average correction increases
from 4% to 12%. The number of volatile days nearly doubles ... the average return in the following years are still up... "
But low volatility years tend not to repeat. When you review the chart above, you will understand why we have told investors to prepare for higher volatility this year. On the right side of the chart, in the years that follow low-volatility, stock prices tend to jump around a lot. The average correction increases from 4% to 12%, a 300% increase. The number of volatile days nearly doubles, from 20 to 38. But, what about returns? It’s very important to note that the average return in the following year is still up at 5%.
In short: while future performance can not be predicted, it would not be surprising if 2018 is both more volatile, but also modestly positive for investors.
On a daily basis, equity markets move almost by popular sentiment and investor psychology. But over time, equity prices are anchored to valuations based on company earnings and future expected profits. As shown by the research above, a healthy market correction is overdue. But it is also typical and generally positive for long term returns.
Sources: Bloomberg News, Strategas Research Partners, LLC