Earlier this week, someone asked me about a popular and frequently-cited market statistic. It goes like this: The U.S. stock market has historically delivered a return of 10%, on average, per year. However, if an investor had missed just the five best days over the past 30 years, that return would have been cut to just 8.6% per year. And if the investor had missed just the fifteen best days, the return would have been reduced even further, to 6.5%. Missing the best 25 days out of that 30-year period would have chopped an investor’s returns in half—to just 4.9%. And because those figures all refer to average annual returns, the compounded effect over 30 years would have been enormous.
As you might guess, the reason these statistics are cited so frequently is to caution investors against trying to time the market—jumping in and out in an effort to sidestep downturns. It’s an important message because market timing can be tempting, especially in a year like we’ve experienced so far in 2022. Both stocks and bonds have lost money, and many are worried that it could get worse. Investors are warily eyeing the Fed, on the one hand, and Vladimir Putin, on the other. And especially as tensions mount around Russia, investors could be forgiven for entertaining the idea of a little market timing to help ease the impact on their portfolios if Russia did roll into Ukraine.
That’s why I think it’s useful to understand the behavior of the stock market in as much detail as possible. Coming back to the question I received—about the impact of missing a few of the market’s best days—I realize that these statistics are counterintuitive. Five days out of 30 years translates to less than 0.1% of trading days. How could such a tiny fraction of days have such an outsized effect on long-term returns? On the surface, it doesn’t make a lot of sense. To better understand this, it helps to examine the dynamics that underlie these statistics.
The first, and maybe most important, dynamic: In the stock market, it’s often at the point when things look most discouraging that they begin to improve—sometimes rapidly. Veteran investor Jeremy Grantham cites the Great Depression as an example. In 1933, when unemployment was still rising and the economy was by no means out of the woods, the S&P 500 rose 105% in the space of just five months. A similar move occurred during the doldrums of the 1970s.
We witnessed the same thing in 2020. The stock market began to recover in the spring, even when it was virtually impossible to see any light at the end of the tunnel. Schools and businesses were still shuttered, and vaccines were many months away. Yet on March 23, 2020, the S&P 500 hit bottom, and from there, it proceeded to gain 68% through the end of the year.
This is a pattern that’s repeated many times over the years. And this is why it’s so tricky to try to time the market. But why exactly does this occur—what causes the market’s mood to shift from pessimistic to optimistic so quickly? In most cases, it’s one of two factors.
The first is government action. This can take two forms. Fiscal policy refers to action taken by Congress, while monetary policy describes action taken by the Federal Reserve. In the most recent crisis, in 2020, we saw a combination of both. On the fiscal side, Congress issued a series of stimulus payments to individuals, and it helped businesses stay afloat with programs like the Paycheck Protection Program.
On the monetary side, the Fed took even more dramatic action. On a single day, it announced a long list of new and expanded programs to support the economy. What day was that? March 23, 2020—not coincidentally, the day when the stock market began its turnaround. The very next day, the market jumped 9%. To put that in perspective, the standard deviation of daily returns in the U.S. stock market is about 1%. In other words, returns are within just 1% on the vast majority of trading days. So 9% is an almost unheard-of move for the market in a single day. But when the Fed marches in with its bazooka, that’s what can happen.
Standing in March 2020, no reasonable person could have guessed that the stock market was about to stage its fastest rally on record. I distinctly remember, in fact, one person worrying out loud that we might be heading into a period not unlike the Great Depression. No question, it was scary. But this episode perfectly illustrates why market timing is so difficult. An investor who had chosen to stand aside while the dust settled back then would have missed significant gains.
The second factor that can drive the market: Wall Street research departments. Every day, brokerage firms’ analysts publish their views on the market and on individual stocks. In ordinary times, these reports don’t have great predictive accuracy. Analysts have a hard time forecasting where the market is heading next. But when the market hits extreme lows, their forecasts can be more useful. That’s because there definitely is a correlation—at a very high level—between market valuation and future returns.
Consider a stock that normally trades at a price-to-earnings (P/E) ratio of 20. If the stock drops to a P/E of 18, it’s debatable whether or not it should be considered undervalued. It might or might not rise back to a 20 P/E. But if that stock were to drop to a P/E of, say, 12, it would be a lot easier for an analyst to make a credible argument that it’s undervalued. At a point like that, the analyst doesn’t need to be too accurate. He or she would just need to observe that the stock is near the bottom end of its historical range and that, therefore, it’s more likely to rise than to fall. Even if the stock only recovered back to a P/E of 15 or 17, an investor would do quite well.
No single analyst can move the market too much. But collectively, analysts and other market observers do have an impact. And when enough market observers start to read from the same song sheet—that the market is undervalued—that can spur the market higher. Warren Buffett offers a case in point. On October 16, 2008, when the market was in the midst of a steep drop, he wrote an opinion piece in The New York Times. He started by acknowledging that no one can forecast where the market will go in the short term: “I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now.” And, in fact, stocks were quite a bit lower a month after he wrote those words.
But he continued, “What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up.” And he cautioned, “…if you wait for the robins, spring will be over.” That was the key point, and that’s exactly what happened. Unemployment continued to rise for another twelve months, but the stock market hit bottom less than six months later. An investor who had waited for clear signs that the economy was improving would have missed out on significant market gains.
Where does this leave investors today? Just like in 2008 or in 2020, no one can say whether the market will continue to deteriorate or when it will recover. But as the statistics show—and as these historical examples confirm—it’s best to stay invested through thick and thin. Investors who wait for an all-clear signal may be disappointed.
