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What history shows you about the market's current rally

Recent history suggests this sort of market behavior is not unusual, however a longer span of market history suggests the response to the pandemic has played out in fast-forward compared to past crises, and further volatility could be on the cards if certain decades of history are any guide.

Article originally published by Forbes. Hargreaves Lansdown is not responsible for its content or accuracy and may not share the author's views. News and research are not personal recommendations to deal. All investments can fall in value so you could get back less than you invest.

The sharp decline in the stock market from late February to March of this year was unusually severe given the size and speed of the market drop. The subsequent rally was unusually strong too. The S&P 500 is now less than 10% off the February highs. In fact, the Nasdaq NDAQ is up for the year so far.

While it may appear jarring, recent history suggests this sort of market behavior is not unusual, however a longer span of market history suggests the response to the pandemic has played out in fast-forward compared to past crises, and further volatility could be on the cards if certain decades of history are any guide.

Ups And Downs

Strong declines pared with powerful recoveries are not unusual in the stock market. 2008-9 is the most obvious example. In fact, we have numerous examples in recent decades, such as the dot com crash in 2000 and multiple market declines during the 1980s.

Still, what’s unusual about 2020 is just how rapidly the drop and the rebound have occurred. For example, the 2008-9 financial crisis took approximately a year on the way down and a similar length for the primary rebound. Other recent declines paint a similar picture. It can take the market around a year to reach a bottom, if recent market drops are any guide.

In that context, the recent drop is remarkably swift. It took under 5 weeks. Of course, Black Monday of 1987 saw the markets fall almost 20% in a single day, that is a faster decline than we witnessed earlier this year. However, even in the case of 1987 the markets took several months to begin to recoup much of the losses. The markets drifted downward for months after Black Monday, even though the day itself gets all the press.

So the speed of the drop we saw in 2020 combined with the rapid resumption of meaningful price rises is unusual in recent history, like a typical crisis, but accelerated. We should note that history is still being written and we don’t know how the markets will trend for the remainder of 2020 and beyond, so can history offer any guide to future market direction?

The 1930s And 1970s

For those who take a bearish view, the 1930s are a potential omen. Though most declines and falls in recent history have taken longer on the way down and longer on the way up, the 1930s paints quite a different picture for the markets. The entire decade is almost filled with violent swings in the stock market. Yes the decade as a whole was certainly a losing one for investors so the downswings dominate for the buy and hold investor, but that conceals eight distinct and powerful stock-market rallies during the decade. The 1930s were marked by volatility throughout, unlike in more recent history where any more extreme downward moves have been followed, sooner or later, by a rally. This is why those who are bearish use the 1930s as an analogy. It shows how the current rally may not be sustained.

The inflationary period of the 1970s and early 1980s too provide some ammunition for bears. Here too there were violent swings in the markets, and though the overall direction was not quite as bearish, markets did tread water for much of the decade. Many apparent recoveries from market lows were then met with subsequent declines. Many rallies did not hold during the 1970s just as in the 1930s.

What Next?

So you can pick your analogy, periods such as the 1930s and 1970s suggest that the current rally may not hold and protracted volatility may be on the cards. Still most other periods of market history, in fact, just about any other decade from modern history, imply that we are now in a recovery that has legs.

There is one worrying sign though. It’s valuation. Valuation has been a market punchbag in recent years. It hasn’t had much predictive power for market direction of late, even though it’s long-term track record is still pretty good.

In the late 1920s the market hit a Cyclically Adjusted Price to Earnings ratio (CAPE), a long-term valuation metric, of 32x earnings. It the late 1960s the market traded at a CAPE of 22x. In both cases high CAPE valuation proceeded a nasty decade for the markets. We entered the pandemic market decline on a CAPE of over 30x. In contrast the average CAPE going back to 1900 is a much lower 17x.

This suggests that the best ammunition for bears might not be to pick any particular historical period, but to point to current valuations. Rebounds of the type we have recently witnessed are certainly not uncommon. Yet the market’s future direction may be informed more by its relatively elevated valuation than the path the pandemic recovery takes. Indeed, if valuation is the main driver for long-term stock-market performance, then the newsflow associated with the pandemic might actually be less significant than we think.


This article was written by Simon Moore from Forbes and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.

Article originally published by Forbes. Hargreaves Lansdown is not responsible for its content or accuracy and may not share the author's views. News and research are not personal recommendations to deal. All investments can fall in value so you could get back less than you invest.

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