A Fourth Good Year for Stocks?

It’s been a very good three-year stretch for large-cap stocks. The annual total returns for the S&P 500 index during the 2012-2014 period have been 16.8%, 32.4% and 13.7%. In contrast, the Ibbotson SBBI Classic Yearbook lists the long-term annualized total return for large-cap stocks as being 10.1%.

Not everyone saw those good returns last year. Domestic small-cap stocks lagged and international markets had their own problems. Preliminary data suggests many active managers struggled to keep up. But the headlines focus on large-cap stocks, and last year was the third consecutive good year for the Dow Jones industrial average and the S&P 500.

The question going forward is whether large-cap stocks can put in a fourth consecutive year of positive returns. Market strategists think they will. Last week, the Wall Street Journal published a summary of forecasts made by 22 strategists and compiled by Birinyi Associates. The average projection called for the S&P 500 to be up 8.2% this year. Six strategists expect another year of double-digit gains. Stephen Auth of Federated Investors was the most bullish, predicting a 14.1% gain. The two most pessimistic strategists weren’t very downbeat, however; Jonathan Glionna of Barclays and David Kostin of Goldman Sachs both predicted a 2.0% gain for the S&P 500.

The calendar is giving mixed signals as to whether the optimism of market strategists is warranted. As AAII founder and chairman Jim Cloonan noted in the October and November AAII Journal, years ending in a five have been positive for stocks. Year three of the four-year presidential cycle has also been positive for stocks. The Stock Trader’s Almanac shows 1939 as the last year that large-cap stocks were down during a pre-presidential year. On the other hand, the Santa Claus rally failed to materialize this year. Thanks to today’s upward move, the first five days of January are positive. The January Barometer won’t be set until the end of this month, though a down January may signal either a flat or down full-year as opposed to simply a down year.

Looking at the age of the bull market or the number of consecutive years with double-digit gains doesn’t give a clear answer either. Sam Stovall at S&P Capital IQ counts 11 bull markets as having existed since World War II, prior to the current one. Their durations range from a little over one year (May 1947 through June 1948) to over nine years (October 1990 through March 2000.) Both the average and the median length are about four years, but there is enough variance in the numbers and a small enough sample size that I wouldn’t put much weight on what the typical duration of a bull market has been. The Ibbotson SBBI yearbook shows several past periods where large-cap stocks have gained double-digit returns over periods of three and four consecutive years. Though infrequent, I wouldn’t necessarily say sequences of this duration are unusual. There simply is not a “use by” date we can attach to the current rally.

Valuations are a point of argument. Yale professor Robert Shiller’s cyclically adjusted price-earnings (CAPE) ratio stood at 27.34 as of December 19, 2014. It was last higher in July 2007. The indicator peaked at higher levels in 1929 and 2000. The ratio has gained attention, though Shiller told CNBC last month that while he wouldn’t over-invest in the stock market, he wouldn’t advise getting out either. Thomson Reuters calculates S&P 500 as currently trading at 17.0 times trailing earnings and 15.8 times forward-looking earnings. While neither number is cheap, they are not overly expensive either.

There are, of course, other factors not reflected in the above data. Oil is a wildcard and nobody knows when or at what price it will bottom. Europe is trying to fight off deflation. Members of the Federal Open Market Committee have been projecting 2015 to be the year of the first rate hike since 2012 (13 members said 2015 would be the appropriate year for raising rates at the December 2012 meeting), though the actual decision still depends on how the economic data unfolds. There is also the potential for either a wildcard event or something not getting a lot of attention right now to move the market. In other words, crystal balls remain very cracked.

Certainty is comforting, but investors get rewarded for taking a chance on uncertainty. Those who stayed on the sidelines during the current bull market have incurred a significant opportunity cost. A big part of investing is setting aside fears and realizing that the money being put into stocks is money you need to grow over a period of many years. Wall Street wants you to be focused on the short term so you will trade more often, thereby generating more fee income. Part of your job as an individual investor is to realize that your biggest risk is whether you will have enough wealth over the long term, not what the market may or may not do this year.

As far as whether 2015 will be a fourth good year, the possibility is out there. The market is not in bubble territory (though it is admittedly not cheap either), but stocks will need the help of continued economic expansion, earnings growth and no major negative shocks.