🕰️ A history lesson

Hey hey, happy Monday!

What a decade last week was.

I’ll talk more about that in a second. But before we get to business, I want to shout out Michael Cordaro at Alliance Wealth Advisors for one of the most enjoyable conversations I’ve had about how young investors think. It’s a good one, listen in here.

Also, I was in the Wall Street Journal and Yahoo Finance talking about how the stock market is finally waking up.

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We just witnessed a series of historic events.

And I can’t stop thinking about one of them.

Last week, small stocks – represented by the Russell 2000 – rose a blistering 11.5% in the five days ending July 16.

An 11.5% gain in such a short span is stunning, no matter the stock. What’s more stunning, though, is just how quiet the rest of the stock market was. The S&P 500 rose just 1.6% over those same five days. Comparing small to large, this marks the widest five-day performance gap in history.

That…probably wasn’t the historic event you thought I was referring to. It’s been a week for history books in more ways than one.

But no matter the subject, the same response holds true: when history happens, people want to know what happens next.

We cling to any tidbit from the past that looks remotely similar, in hopes that there’s some truth in past events. Sports stats, album sales, presidential assassination attempts, market crashes – we all love to find those historical parallels.

I’m guilty of this too: I’m an avid historian, and I’ve built a brand around uncovering quirky market stats like the one you just read.

So in a way, I’m extra qualified to say this:

Stop relying on history to tell you what happens next.

It’s a dependable guide, but a terrible signal of what’s to come.

Let’s get back to that monumental rally in small-cap stocks.

What if we gave into the urge to go back in time and look for market patterns?

Sure, it was the biggest performance gap in history, but you’d be able to find a few similar situations:

Here’s a table of the top 10 biggest small-cap rallies vs. large-cap stocks over the past 50 years:

If you calculate the average returns for small stocks and large stocks over the subsequent month, you’ll see that the S&P 500 rose 2.6%, while the Russell 2000 dropped 0.2%.

That’s a good example of a 267-character historical analysis that fits neatly into a Tweet. Short, concise and perfect for our shrinking attention spans.

Based on that quick math, you’d probably conclude that it’s time to buy stocks.

But it’s not that simple. It rarely is.

Historical analysis always requires context.

Here’s the same table, with additional context: average returns, plus the market’s distance from record highs and a comment on what exactly was going on at the time.

Now, the conclusion looks a little different. A lot of these rallies look more frantic than encouraging. In some instances, the market was careening from record highs, and in others it was bouncing from multi-year lows. Small stocks trounced large stocks in radically different environments – while banks were failing, tech bubbles were growing and a deadly virus was spreading.

In some scenarios, buying stocks paid off. In others, not so much.

For what it’s worth, I don’t think small stocks are sending an ominous signal about a looming crisis. Today’s action – and the context – actually makes me more optimistic because stocks outside of tech seem to be rallying on hopes of helpful rate cuts and a buoyant economy. Not because the average return from a sample size of 10 says so.

Taking a slice of history as gospel ignores can lead you astray – even if it makes you feel better in the moment.

Here’s another popular chart that’s been making the rounds – how the stock market performs during election years:

One look, and there’s an obvious takeaway: stocks tend to fall late in the election season.

Based on averages, you’d be right. But the average is deceiving without context.

2008 – the year of the global financial crisis – was a presidential election year. In October 2008, the S&P 500 fell 17%, the second-worst monthly return in seven decades. People sold stocks because banks were failing and unemployment was soaring. The economy was crumbling before our eyes.

Take 2008 out of the average, and you get a much different picture of how stocks have handled an election year.

One outlier year makes the election season seem scarier than it really is. And don’t get me started on how this isn’t your average election season.

Now, I’ll admit that a lot of this is semantics. None of this analysis would pass the statistician sniff test or make it into an academic paper.

Still, studying history can reveal important lessons. Decades of data can show you that the broader market follows the economy over time. Changes in interest rates can shift preferences for stocks, bonds and other markets. Inflation and job loss can roil confidence.

And most importantly, humans are gonna human.

Our emotions have been with us since the dawn of time, and they’re going to impact our investing decisions. Big mood shifts among the general population can move markets. 

Be very, very careful with drawing conclusions from history. And be very, very skeptical of anybody saying they know what happens next because of lines on charts or numbers in polls.

History doesn’t repeat itself, but it often rhymes.

Thanks for reading!

Callie

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