Shiller price index

The stock market had history on its side. Now that is not the case.

Last month, when the S&P 500 Total Return Index had recouped half of its 2022 losses, I highlighted the historical appeal of buying stocks under these circumstances. I warned that past performance does not indicate future results and that stocks are essentially a random walk. Nonetheless, stocks have some momentum and buying with this tailwind, along with valuations still well below the peak, with history on your side, seemed easier than buying stocks at other times.

So unless the S&P 500 ends well this week, we’ll only have the second time since 1873 that buying midway through the rally was a mistake – and I’ll get more angry emails . Let’s see if we can figure out how I got it wrong.

The chart below shows the 24 month-end S&P total return index declines of 15% or more since 1871. The midpoint is the first month-end after the 15% loss at which the index had recovered the half of its value. The column titled “New Peak/Trough Date” is the first month end after the Midway Recovery Date when the index either established a new all-time high or broke below the crash loss point. before the restart. Yield measures what an investor has gained by buying stocks on the midway trade date and holding them until a new high or low is established. Only once – the purchase at the end of April 1930 – did this strategy lose money. On 22 other occasions, the S&P 500 total return indices hit a new all-time high before falling below the crash low.

If September 2022 ends at the current value of the S&P 500, we will have our second exception in 151 years. So what’s different between April 1930 and August 2022 compared to the other 22 times the S&P 500 recovered halfway?

The first word that comes to mind is “value”. Buying midway through the recovery is a dynamic strategy, betting that “the trend is your friend”. Momentum strategies are among the oldest and most trusted tools used by professional traders and quants. But momentum works best when paired with value, which means buying things cheap. If you can find cheap products that are also increasing in price, you often have an interesting opportunity. Momentum is great on average but can cause you to buy in bubbles or sell in panics. Value is great in the long term, but the long term can be very long. When you get both value and momentum, you’re not sure to make money, but that’s about the best position an investor could hope for.

The best common measure of stock market value is the cyclically-adjusted price-to-earnings ratio, or CAPE, by Professor Robert Shiller of Yale University. It has averaged 17 since 1871, which means that the S&P 500 has averaged 17 times the average annual inflation-adjusted earnings over any 10-year period (the most usual price-earnings ratio uses the last 12 months of earnings, expected future earnings or other short-term earnings). long-term measures, and therefore rebound with the economic cycle). But CAPEs in the 21st century are higher, averaging 26.

The last column of the table indicates the CAPE at the mid-term recovery date. The first two entries are NA because there isn’t 10 years of income history to calculate them, but they would probably be around 15 if we had the data. You can see that 20 of the 22 hits happened when buying at CAPEs of 20 or less. When CAPE was over 20 years old, there was one failure in 1930, two successes in 2004 and 2020, and a probable failure in 2022.

The scary thing is that the last time that happened it took 16 years, the biggest economic depression in history and the biggest war in history to bring CAPE down to 11 and launch the next cycle of prosperity. I don’t foresee anything like that, of course, but it seems that the market decline in the first half of 2022 was not enough to remove the economic deadwood and deflate the bubbles. There may be more pain to come. More from Bloomberg’s opinion:

• So you say you are bearish, but are you really? :Jonathan Levin

• Why investors face even more instability: Mohamed El-Erian

• CME becomes DraftKings of Exchanges: Jared Dillian

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Aaron Brown is a former Managing Director and Head of Capital Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street”. He may have an interest in the areas he writes about.

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