Is there such a thing as a "normal" stock market?

By PATRICK CAIRNS

Everyone would agree that the first few months of 2020 have been extraordinary. Few of us would have imagined living through something like the Covid-19 pandemic.

Economies have been disrupted, political stakes have been raised, and markets have been in turmoil. It feels like there is nothing “normal” about what has taken place since the world realised that the spread of the virus would not be restricted to Asia.

The market crash that began in mid-February and the recovery since have been the swiftest in history. Earlier this month the S&P 500 briefly closed higher than where it started the year. It remarkable that, despite the huge sell-off, the US stock market was back to where it began 2020 in a matter of weeks.

The illusion

It is easy to characterise this as abnormal market behaviour. Certainly many people have called it irrational.

However, for anything to go through an ‘abnormal’ phase, it must also have a ‘normal’ one. So, what does a ‘normal’ market look like?

Consider that since the S&P 500 officially became constituted of 500 stocks in 1957, its annual average return has been a little over 8%. Over all that time, however, it has never actually produced an 8% return in a calendar year.

In fact, in all of those 63 years, the index has only returned between 7% and 9% on four occasions.

It has more commonly produced an annual return of between 19% and 21%. That has happened five times.

Average is not normal

What that clearly shows is that we cannot equate ‘normal’ with ‘average’. This is not just true over the short term.

The 10-year annualised rolling return on the US market over more than 80 years is just more than 10%. It has, however, still shown an enormous amount of variance. It has been as high as 20% in the 1950s (and came close to that again at the height of the dotcom bubble in the late 1990s), and on six occasions since 1937 it has been negative.

What this suggests is that, in fact, what most characterises the stock market is unpredictability. It is perfectly ‘normal’ for the stock market to move in ways that haven’t been seen before are are largely unexpected.

Just as the 2020 coronavirus crash was an entirely new experience, so was the 2008 financial crisis, and the bursting of the dotcom bubble in 2001. Each had a distinctly different cause and played out in a unique way.

The positives

Ironically, this unpredictability is cause for optimism rather than fear. It is the risk any investor must take when investing in stocks. But it is a risk that has consistently been rewarded.

As Elroy Dimson, Professor of Finance at Cambridge Judge Business School and co-author of the book Triumph of the Optimists points out, the stock market has persistently out-performed bonds and cash in countries all over the world over more than 100 years.

This is not, however, what an ordinary investor back at the turn of the last century might have expected.

“Our view was that back in 1900 only real optimists would have poured their money into industrial and commercial common stocks,” says Dimson. “Many risk-averse investors would have played safe with government securities.”

Expect the unexpected

While stock markets were undoubtedly even more volatile 120 years ago, Dimson’s observation still holds true today.

Particularly when the market goes through these periods of extremes, it can seem far too risky a place to put one’s money. Cash and bonds feel far more ‘safe’.

Stocks have, however, always delivered these kinds of surprises. One can also be certain that they always will.

This should not be seen as ‘abnormal’, but exactly the opposite. It is a reminder that the stock market will always be a risky place. But those who can manage that risk and see through the short term to their long term goals will likely always be rewarded.