What Makes A Good Year For Stocks

Martin Fridson wrote It Was A Very Good Year, which studied high return years in the US Stock Market in the recent century. He recounts the events in history and attempts to find some pattern or commonality in the attributes that led to those years.

Here is an excerpt of his chapter on “What Causes The Very Good Years”

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Some readers derive intrinsic pleasure from studying history, but investors have a practical motivation. Future opportunities may emerge from conditions that resemble those responsible for rich rewards of the past. For example, by correctly understanding why annual returns have occasionally topped 35%, stock market participants may learn to tell when it’s about to happen again.

To anticipate the great booms, it’s necessary to filter out voluminous information that has no bearing whatsover. The trouble is, it’s hard to ignore irrelevant facts to which market pundits and financial journalists assign immense signficance. And to be fair, some facts that shed no light on the extremely good years may be quite useful in handicapping the market’s more mundane fluctuations.

The brief analysis that follows doesn’t purport to explain every 5 percent or 10 percent swing in the Dow. Recapitulating the historical experience does, however, enable investors to zero in on the circumstances that produced the maximum returns.

The Candidates

Any devotee to the financial pages can rell off several possible explanations for the great bull years. The following, which are not mutually exclusive, probably represent the most common theories:

Anticipation of a Corporate Profit Rebound
The market assesses the value of common stocks as a function of current or expected future earnings. Because investors are by nature forward-looking, they begin to bid up stocks well before the general level of corporate profits rises.

Psychology Shift
Stock prices are driven by emotion. From time to time, a wave of pessimism abruptly and inexplicably gives way to optimism. Suddenly, price-earnings ratios seem low, impelling investors to scramble for bargains. The scrambling continues long after the bargains disappear. Prices therefore excalate, without regard to instrinsic value, until euphoria once again yields to despair.

Very Long Cycles
Deeply embedded in the structure of capitalism is a tendency for major discontinuities to occur every so many years. Probably as a result of technological upheavals, massive new wealth is created in fitful spurts.

Action-Reaction
Sotcks follow a regularly recurring cycle of accumulation and distribution. Prices predictably rise and fall in repsonse to these market technicals. Following a big downturn, a huge upturn is inevitable according to this theory.

Easing of Credit Conditions

When the Federal Reserve loosens its grip on the money supply, stock prices benefit in several different ways. For one thing, the corporate earnings outlook improves. Reduced interest rates enable companies to build up their inventories and increase their customers’ credit lines. To the extent that price-earnings ratios determine stock values, a jump in ranings neccessitates a jump in the index. A second, more direct impact on stock prices derives from the increased availability of loans for financing securities purchases (or margin). Finally, a drop in interest rates reduces the attractiveness of fixed-income investments, relative to equities. The logical consequence is a shift of investment captal from bonds to stocks.

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Fridson takes the above ideas and matches them against historical facts in his book. Good read.