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What Will the Stock Market Do for an Encore?

It’s been an incredible, even historical, year for stock-market gains, but the record shows it’s most likely the coming year’s returns will be merely average.

I have both good and bad news about the stock market’s spectacular return over the past 12 months.

Since the bear market low one year ago, the S&P 500 (with dividends) has gained an incredible 78%. You have to go back to the 1930s, in the middle of the Great Depression, to find another 12-month period with returns this impressive.

The good and bad news have to do with how the stock market typically performs following well-above-average years. The best bet is that the stock market will turn in a merely average return.

The reason this might be bad news: You may have been hoping that the stock market had built up a head of steam that would carry through to above-average returns this coming year. In contrast, this reading of history might be good news if you had been worrying that exceptionally strong stock market years are followed by particularly weak ones.

The reason neither one of these good- or bad-news scenarios is likely traces to a fundamental property of the stock market: It is a discounting mechanism that, instead of driving by looking in the rear-view mirror, focuses on anticipated future returns. It does not take past performance into account.

Think of it this way. If the past 12 months’ stellar return meant there were good odds of above-average returns over the next 12 months, then the market would have already risen to reflect those good odds. It would have stopped rising at the point the odds of the market rising were no better than average.

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Similarly, if there were better-than-even odds that the market would be a poor performer over the next 12 months, then the market would have already fallen to reflect those odds. It would have stopped falling at the point the odds of the market rising were no worse than average.

In short, the market will stop going up or down at whatever point translates into average chances of the market rising over the coming year. That’s the theory, at least. Yet it’s remarkable how close the real world lives up to theoretical expectations.

Consider the 50% of rolling 12-month periods since 1871 in which the S&P 500’s return was the best. Over the subsequent 12 months following those periods, the S&P 500 rose 69.7% of the time.

The comparable percentage following the 50% of 12-month periods with the worst returns, in contrast, is the nearly identical 68.2%.

The bottom line: You can draw no inferences about the next 12 months from the market’s spectacular performance over the past 12 months.

Note carefully that this discussion doesn’t mean there aren’t other reasons why the market may do better or worse than average between now and a year from now. My point is that if you want to argue that it will deviate from the average, you will need to base your arguments on factors other than the stock market’s spectacular gain over the past 12 months.