The stock market rebound has history on its side

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The recent rebound in the benchmark S&P 500 index brought it back to more than half of its 2022 low point in mid-June, which is an encouraging sign for many investors. It is certainly one of the most statistically reliable stock market signals. But does that mean it’s safe to get back into stocks?

Since 1926, stocks have recovered more than half from a decline of 10% or more 79 times and only once, in March 1930, did the market hit a new low before setting a new all-time high. Additionally, the average return for the month following the 50% point is 2.7%, above the average of 0.9% for all months. The year after is on average 16.0% against 12.7% for all years. Volatility is also below average after the 50% point.

Remember that past performance is not indicative of future results. And we know that the stock market is pretty close to a random walk, so making investment decisions based on patterns in charts is a risky game. On the other hand, strong statistical patterns in stock returns are the primary way to learn more about the markets. And we can tell a plausible story about this model. Something bad happens and stocks go down. The decline scares many people who are fleeing the market. It exposes weak hands that are forced to sell or even go bankrupt and dispose of their assets. Few new investors are brave enough to buy stocks. For these reasons, stocks fall more than the fundamental news warrants and stay down longer.

By the time the accumulation of good news erased half of the losses, under the effect of pessimism from investors, we have probably put the bad behind us and are on a new recovery. But prices are still lower than they should be due to investor fear. We can expect old investors to start returning to stocks, new investors to enter, and optimists to increase their leverage. As the headwind turns into a tailwind, stocks should do better than average for a while. The most courageous investors “buy when there is blood in the streets”. It’s not that bold: “Buy when half the blood is gone, but most people are still hunkered down at home.” If you wait for the streets to be cleaned, you should expect to pay top dollar.

We can get a more accurate picture by looking at the performance of equity-related factors the previous 79 times the market has come back halfway from a decline of 10% or more. The oldest and best-documented equity factor is size, with small stocks outperforming large stocks by around 1.5% per year on a risk-adjusted basis. This is generally seen as a reward for finding more obscure and less liquid stocks with less information available and sparser analyst coverage, some of which is too small for larger institutions to care about. In the month following a 50% rally, small stocks beat large stocks by 1.9%, and in the year after by 3.6%, both figures well above normal outperformance from 0.1% to 1.5%.

Another popular factor is value, or stocks that are priced low relative to fundamental measures such as book value. Value stock picking typically rewards investors with a 4.3% annual advantage over more expensive stocks. The value roughly averages in the month after a 50% recovery, a 0.4% advantage vs. 0.5% on all months, but disappears in the year after a recovery, providing an advantage of 0, 1% against an average of 4.3% over all months. So, halfway through the recovery, it’s too late to beat value investors because all the Warren Buffetts have already bought all the big stocks. You have to go to the smaller and more obscure stocks for maximum exploitation of the situation.

What about the momentum factor? This involves buying stocks that are going up and short selling stocks that are going down. Momentum is actually negative after 50% recovery. It costs you 1.9% the month after a 50% recovery and 0.3% the following year, compared to average gains of 0.6% per month and 7.2% per year in normal times. Entering because the market is rising is a game of momentum in timing, but history shows that you shouldn’t double down on picking the fastest rising stocks. Opt instead for a selection of anti-momentum stocks, buying the stocks that continue to fall, or at least have not risen as much as the others.

None of this is investment advice. Buy your own shares – or not – for your own reasons, and take your gains or losses as you go. But when the common sense stories are consistent with the statistical patterns of the past, you may be able to invest with a little more confidence than usual.

More other writers at Bloomberg Opinion:

The Fed Must Resist the Quick and Easy Choice: Mohamed El-Erian “The End of the Beginning” of the War on Inflation: John AuthersDon’t Buy the Stock Rally? Smart Money Made: Robert Burgess

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.

More stories like this are available at bloomberg.com/opinion

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