Last week, LPL Financial published an interesting and apparently compelling piece concluding that when equities are up 6% or more with 100 days to go in the year, like in 2016, the rest of the year is up 90% of the time with a +5.3% average gain.
Going back to 1928, the S&P 500 has been higher year to date 56 times with 100 days to go. The rest of the year has averaged a return of 4.2% and has been higher 83.9% of the time. The flip side is when it is down year to date with 100 days to go, the rest of the year is down 2.3% on average and higher only 42.9% of the time. In other words, a strong start to a year historically leads to higher prices to end the year and vice versa.
Now, what happens if it is a strong year? There have been 40 other times the S&P 500 was up more than 6% for the year with 100 days to go (like 2016), and incredibly, the rest of the year is up 5.3% on average and higher 90% of the time. Thus, a strong start to the year has led to even stronger returns for the rest of the year. What about the full-year returns? Only once in history has the S&P 500 been up more than 6% with 100 days to go and finished red, and that was in 1929. Therefore, 39 of the previous 40 times the full year finished green, making the chances for a massive sell-off during the rest of this year rather slim.
Always curious and suspicious, Bearnobull digged deeper and found the following rather important facts, considering that the current P/E on the S&P 500 Index is 19.1x trailing EPS and the Rule of 20 P/E (which takes inflation into account, important when analysing long periods) is 21.4 with still declining EPS and accelerating inflation:
- In 30 of the 40 instances (75%), the Rule of 20 P/E was at or below the 20.0 “fair value” level. Above 20, the valuation downside risk rises above the valuation upside potential making the risk/reward ratio unfavourable to investors.
- In 7 of the 10 “higher valuation risk” instances, EPS were on an uptrend, helping mitigate the valuation risk somewhat.
- In all 3 other “higher valuation risk” instances (declining EPS), inflation was declining, also helping mitigate the valuation risk somewhat.
- Six of the 10 “higher valuation risk” instances ended badly with subsequent drops ranging from –5% to –30% and averaging –18.3%. The other 4 such instances were either at the bottom of economic cycles (1991 and 2003), or saw strong EPS growth (1997 and 1998).
In all, it is rather dangerous to conclude that we are in a 90% probability scenario for a rising equity market simply because it has been rising so far this year: current valuations are historically elevated which necessitates favourable trends in earnings and inflation to sustain investor enthusiasm, trends which are currently not present.
Here are statistics which incorporate valuations and are thus much more significant:
- Since January 1927, the S&P 500 Index has traded at a Rule of 20 P/E above “20” 34% of the time and above the current 21.4 only 20% of the time. When trading above 20, the S&P 500 Index returned +0.2% on average (median: +1.6%) during the 6 months following (46% positive) and +2.2% (median +4.8%) during the 12 months following (41% positive).
- When at or above 21.4, the current reading, the average 6-m return was –1.1% (median +0.8%, 47% positive) and the 12-m return –0.4% (median +3.1%, 48% positive).
- When the Rule of 20 is below “20”, i.e. in the lower risk area, the average return is +5.6% six months out (median +6.2%, 71% positive) and +10.5% twelve months out (median +12.3%, 73% positive).