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Are good years in the stock market followed by bad years the next?
The belief that they are has gotten many retirees and soon-to-retirees worried. That’s because, based on year-to-date performance through mid-December 2019 is shaping up as one of the better years in U.S. history for the stock market.
Assuming the Dow Jones Industrial Average DJIA, +0.59% closes the year at where it is in the second week of December, in fact, 2019 will be the 4th best year of the last two decades—and higher than 72% of all calendar years since this benchmark was created in the late 1800s.
Fortunately you can relax. The stock market’s strong year-to-date performance does not reduce the odds of a good 2020.
To be sure, a good 2019 does not increase 2020’s odds, either. That’s because the odds of the stock market rising in any given calendar year stand at 66%–about two out of three—regardless of how equities performed in the previous year.
Consider the calendar-year gains of the Dow since 1897, the first full year of its existence. In the 122 years since (through 2018), the Dow rose 80 times—65.6% of the time. Now consider just those years in which the Dow rose; in the calendar years immediately following them, the Dow rose 65.0% of the time. Statistically speaking, that is no different than the odds that apply to all years.
Now consider years in which the Dow didn’t just rise, but rise by at least 23.6%. I chose that threshold because that is how far the Dow has risen in 2019 through mid December. The percentage of years subsequent to them in which the Dow rose is 64.7%. Once again, the difference between this and the 65.6% percentage that applies to all years is not statistically significant. (These percentages are plotted in the accompanying chart.)
These results illustrate, once again, the stock market’s much-vaunted efficiency. One hallmark of an efficient market is that its level at any given point incorporates all publicly-available information up to that point. And that’s just another way of saying that the stock market’s subsequent performance will be independent of what came before.
To put it another way: If a particularly strong or weak stock market year markedly changed the odds of it rising or falling in the subsequent year, then investors would already have taken those odds into account before that subsequent year even started. The result would be that those odds would disappear.
These odds that apply to the stock market’s year-to-year fortunes are remarkably analogous to a coin flip. Your coin doesn’t “remember” how many heads or tails it has flipped before; the odds of it coming up heads are always the same.
This is not how most of us think, however. If you’ve flipped five heads in a row, you’re likely to think that there are increased odds that the sixth will come up tails. You’re wrong, of course.
Behavioral economists refer to this error as the gambler’s fallacy. It also exists in the stock market, except the odds of an up year are now 65.6% instead of the 50:50 odds that apply to a coin flip.
Whether you take solace from this information depends on your risk tolerance. Two out of three odds of making money next year appear attractive to many investors. By the same token, retirees typically have a lower risk tolerance, and for them a one-out-of-three chance of losing money is intolerably high.
If that applies to you, and your portfolio is heavily exposed to the equity market, now would be a good time to hedge your bets. You don’t have to get completely out of equities, but you should reduce your equity exposure to whatever level you can live with. By all means consult with a qualified retirement financial planner.
Once you have reduced your equity exposure to your “sleep easy” level, then you can be detached and sanguine if the stock market falls in 2020—secure in your knowledge of history that such years happen one out of every three years, on average.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. Hulbert can be reached at mark@hulbertratings.com.
