With vaccines rolling out, an incoming infrastructure bill and rising rates in the US, what kind of capital markets volatility and returns can US large cap equity investors expect during the balance of this year? We’ll answer that question in two parts, which both come to the same conclusion.
#1: An update on our preferred benchmark for how much investors “feel” real-time volatility, namely the number of trading sessions when the S&P 500 moves more than 1 percent up or down from close to close. Any one-day move greater than 1 pct to the upside or downside is +1 standard deviation from the S&P’s mean daily return back to 1958 (first full year of data).
- There were 18 one percent days in Q1 2021 compared to the quarterly average of 13.
- The S&P moved +/- 1 pct on 110 trading days last year, or roughly double the annual average of 54.
The S&P has only registered 100 or more “plus-one percent days” on seven occasions including 2020, or 11 pct of the time. Some others: 1974 (115 one percent days), 2000 (103), 2001 (107), 2002 (126), 2008 (134) and 2009 (118).
- After the 6 years (prior to 2020) when the S&P had +100 one percent days, it went on to post an average of 27 one percent days in Year 2’s Q1, or roughly double the first quarter average of 13.
Takeaway (1): So far this year, volatility is returning to normal quicker than after prior years of outsized volatility (+100 one percent days). The only other quarter with fewer one percent days in Q1 after said years was Q1 2010 when there were 15 one percent days. For reference, the S&P was up 4.9 percent that quarter versus 5.8 pct for Q1 2021.
Takeaway (2): Lots of liquidity into the US economy and financial system has helped corporate earnings rebound and valuations stabilize quickly. That, along with a solution to the crisis issue (i.e. vaccines) and lower equity sector correlations, have dampened volatility faster than prior post-crisis periods.
Takeaway (3): As we’ve written before, history says the sharp drop to lower US equity volatility we’ve been seeing may limit 2021 stock market returns. For example:
- After 2000 – 2003’s higher volatility (2000-2002 all had +100 one percent days, and 2003 had 83) and dismal bear market, 2004 only saw a 10.7 pct snapback for the S&P 500.
- After 2008 – 2010’s greater number of 1 percent days, 2011 was only up 2.1 pct.
Yes, it’s true that low volatility on its own does not necessarily limit US equity performance (i.e. 2012 – 2015, S&P +21 pct CAGR) and the S&P is already up 5.8 pct YTD. That said, above-average returns have historically required a mid to late-cycle investment environment with robust economic growth.
#2: The S&P posting double-digit returns for three consecutive years is rare given that markets efficiently discount the future, making it tough to outperform historical mean returns that many years in a row. Some background:
- The S&P was up 31.2 pct and 18.0 pct in 2019 and 2020 respectively on a total return basis.
- The S&P has registered two consecutive years or more of annual double-digit total returns 20 times since 1958.
In the year after those instances (excluding 2020), the S&P was positive a little over half the time (58 pct) and up +3.6 pct on average on a total return basis.
- The S&P only went on to produce a positive double-digit return for a third straight year or more during 3 periods:
1963-1965: 1963 (+22.6 pct), 1964 (+16.4 pct), 1965 (+12.4 pct)
1995-1999: 1995 (+37.2 pct), 1996 (+22.7 pct), 1997 (+33.1 pct), 1998 (+28.3 pct), 1999 (+20.9 pct)
2012-2014: 2012 (+15.9 pct), 2013 (+32.1 pct), 2014 (+13.5 pct)
Takeaway (1): History shows that a third year of double-digit returns is unusual, and typically comes amid easing financial conditions and improving earnings such as during the bull run of the 1990s or after the Financial Crisis. Could that happen again with an accommodative Fed and a Democratic President and Congress pushing for more fiscal aid? Yes, as long as rates don’t rise too high…
…But just remember that: 1) it’s more common for two straight years of double-digit returns to be sporadically sprinkled throughout a cycle (which we just had), and 2) corporate margins were already at record highs after the Trump administration’s tax cuts, making it more difficult for public companies to show meaningful earnings leverage versus 2019 unless they’re in deeply cyclical sectors. The Biden administration is also now, of course, trying to raise corporate taxes.
Takeaway (2): this year’s S&P performance will largely stem from how the market discounts 2022’s economic growth and US corporate earnings, but a 3-peat of +10 percent returns would require the rare event when markets underestimate forward earnings 3 years in a row.
In sum, while we remain bullish on US equities, history says returns are typically more muted after the sequence of events we’ve just seen between a quick drop in volatility and already two years of +10 percent returns.