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Why Next Year Could Be Better

This has not been a happy holiday for the U.S. stock market. As of this writing the S&P 500 is down about 20%. The month of December is on track to be the worst for stocks in 50 years, and the large market drop the day before Christmas, ordinarily a quiet trading session, was record-breaking. Yet the news has been mixed. On the negative side we have the ongoing trade war with China, more Federal Reserve interest rate increases, the government shutdown and executive branch political instability, and greater uncertainty around the U.K. exit from the E.U. On the positive side, the Conference Board’s leading economic indicators indicate further growth, and consumer spending (especially during the holidays) continues to be robust. For whatever the reason, investors have chosen to become bearish. Q4 2018 is likely to turn out to be one of the top ten worst quarters for the markets in history.

As I have written many times before, it’s impossible for us to know when investor sentiment will turn around again and the markets will re-experience growth. But you might be surprised at how the S&P 500 had bounced back after bad quarters in past years.

Since 1920 there have been 114 quarters (out of 392) in which S&P 500 performance has been negative.  In other words, 70% of the time quarterly stock market performance has been positive. And of the quarters with losses, most were small (over a quarter of them involved a decline of less than 2%).

What happened afterwards? Let’s take the top ten worst quarterly drops in the S&P 500 and look at the returns over the following 12 months:

Quarter                Return                  Forward 12 Month Return

1932 Q2               -37.7%                                162.9%

1931 Q3               -33.6%                                  -9.6%

1929 Q4               -27.8%                                -24.9%

1974 Q3               -25.2%                                  38.1%

1987 Q4               -22.6%                                  16.8%

2008 Q4               -21.9%                                  26.5%

1937 Q4               -21.4%                                  31.1%

1962 Q2               -20.6%                                  31.2%

1938 Q1               -18.6%                                  35.2%

1946 Q3               -18.0%                                    6.4%

As you can see, 80% of the time the subsequent one-year return was positive, and more than half the time the subsequent annual gain was greater than (and completely made up for) the earlier quarterly loss. If we ignore 1929 and 1931 on the assumption that we are unlikely to experience another Great Depression, the losses were erased in the following year almost 75% of the time.

We cannot know what will happen in 2019. But if history is any guide, the longer we remain invested, the greater the likelihood of positive savings growth. And there is one thing we can be sure of: stocks are considerably cheaper today than they were last quarter. At some point the bargain buying will commence!

(Thanks to Ben Carlson for the data.)

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