Looking into the Rearview Mirror

It is safe to say that we have all benefited from well-functioning capital markets throughout our lifetime.  Efficient capital markets have produced technological and medical advances that have made our lives easier, more enjoyable, and longer.  Efficient markets also facilitate wealth creation and allow us to have higher standards of living and enjoy comfortable retirements.  So it is important to remember that efficient markets will experience occasional periods of volatility as we observed in January.  Free markets continually adapt and react to new information and changing expectations; sometimes with a little more volatility than we are comfortable with.

Market prices in January dragged downward as investors processed new information, and aggregate expectations for market returns changed.  As a result, the S&P 500 index had a -4.96% return for the month.  According to research provided by Dimensional Fund Advisors (DFA), January’s return was the ninth lowest monthly return for the S&P 500 index since 1926.

As investors, many of us are naturally prone to recency bias.  Recency bias is the tendency to believe that trends and patterns we observe or experience in the recent past will continue into the future.   So when we experience a month like January, many investors will naturally predict that the negative returns in January are a harbinger of returns for the remainder of the year.  But market data from the past tells a different story.

Negative January Returns

A bad January start doesn’t always mean markets are headed for a bad year.

 

Exhibit 1 displays ninety years of returns (1926 to 2015) for the S&P 500 Index with both the returns for January and the subsequent 11 months of the year (February through December).  As you can see in Exhibit 1, a positive return for the month of January in the S&P 500 Index does not guarantee a positive return for the index for the remainder of the year.  Nor does a negative return for the month of January in the S&P 500 mean that you should expect a negative return for the index for the remainder of the year.

The data in Exhibit 1 shows that a negative return for the S&P 500 in January was followed by the next 11 months experiencing a positive return 59% of the time, with an average return of 7%.   This would suggest that negative returns in January offer poor predictability about market returns for the remainder of the year.

The Importance of Discipline

The data in Exhibit 1 serves as a reminder of the importance of maintaining a disciplined investment approach at all times.  By reviewing historical data we are reminded that it is difficult to make conclusions or predictions about the future based on what has recently occurred.  It is also difficult to consistently and accurately identify signals that indicate markets are changing course.

It is important to remember that well-functioning, efficient markets will experience periods of volatility (both negative and positive) on occasion.  Some of these periods will be quite short, while others may feel painfully long as we move through them.  But in the long-run, efficient and well-functioning capital markets work and reward patient investors who stick with a disciplined investment strategy throughout all market conditions.

Sources:  Dimensional Fund Advisors, Standard & Poor’s Index Services Group.