SOMEONE ASKED ME last week about a popular and frequently cited market statistic. It goes like this: The U.S. stock market has historically delivered an average annual return of 10%. But if an investor had missed just the five best days over the past 30 years, that return would have been cut to 8.6%. If the investor had missed the 15 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 return in half—to just 4.9%. Because those figures are 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 so tempting, especially in a year like we’re currently experiencing. Both stocks and bonds have lost money, and many are worried that it could get worse. Folks are warily eyeing the Federal Reserve, on the one hand, and Vladimir Putin, on the other. Investors could be forgiven for entertaining the idea of a little market timing.
That’s why I think it’s useful to understand the stock market’s behavior 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? It helps to examine the dynamics that underlie these statistics.
Maybe the 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 just five months. A similar move occurred during the doldrums of the 1970s.
Also consider 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, gained 68% through the end of the year.
This is a pattern that’s been repeated many times over the years, and why it’s so tricky 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 tax and spending action taken by Congress, while monetary policy describes action taken by the Federal Reserve. 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 the U.S. stock market’s daily return is about 1%, meaning returns are within 1% on the vast majority of trading days. A 9% move is almost unheard of. But when the Fed marches in with its bazooka, that’s what can happen.
In March 2020, no reasonable person could have guessed that the stock market was about to stage its fastest rally on record. In fact, I distinctly remember 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 until the dust settled 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 headed 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 valuations and future returns.
Consider a stock that normally trades at a price-earnings (P/E) ratio of 20. If the stock drops to a P/E of 18, it’s debatable whether 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 therefore more likely to rise than 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. 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 Oct. 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.” In fact, a month later, stocks were quite a bit lower.
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.” 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 12 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 gains.
Where does this leave investors today? As in 2008 and 2020, no one can say whether the market will continue to deteriorate or when it will recover. But as the statistics show—and as the historical examples confirm—it’s best to stay invested through thick and thin. Investors who wait for an all-clear signal may be disappointed.