As investors were suffering huge losses last year and the first few months of this year, many of them despaired that good times would ever return. We never doubted that the market would come back, but we had (and still have) no way to know what a full recovery might look like or how long it might last. However, the history of the U.S. stock market is at least somewhat encouraging.

Since World War II the U.S. stock market has had 15 losing calendar years. More than two-thirds of the time, the market rebounded into a positive calendar year immediately after the losing year. This may turn out to be another one of those positive bounce-back years.

Last year, 2008, recorded the biggest one-year Standard & Poor's 500 Index drop in the past 60 years, a loss of 37 percent. Although 2009 is still very much a work in progress, the first nine months of this year resulted in a robust double-digit gain.

Today, investors are more confident than many people would have believed six months ago.

There are of course a million ways to look at past historical data, and none of them lets us see into the future. You can second-guess every question you might ask and keep adding complicating factors.

To keep things simple, we noted losing years for the S&P 500 Index then and asked what had happened in the overall market in the following year.  

In Table 1 below, you’ll see this information not just for the S&P 500 Index but also for indexes that track three other important U.S. equity asset classes: large-cap value stocks, small-cap stocks and small-cap value stocks. This reflects our investment recommendations.

Table 1:  Annual percentage returns of U.S. asset classes in years following losses in Standard & Poor's 500 Index 

* Results through September 30 for 2009 using S&P 500 Index and DFA fund returns.  

As you can see, in each follow-up year we calculated the average of the four asset classes. In 12 of the 14 years after S&P 500 Index losses, investors who owned equal parts of all four asset classes did better than those who owned only the S&P 500 Index. This was not a surprise to us, because we are big believers in diversification. The first nine months of 2009 followed that pattern, too.

Better times are not necessarily here to stay

The mathematics of recovery are not kind to investors. It requires a 100 percent gain to recover from a 50 percent loss. In order to break even from last year’s 37 percent loss, the S&P 500 Index would have to gain 59 percent. We can’t say for sure whether or when that will happen. Recoveries sometimes take off like rocket ships, and sometimes they just fizzle out.

Although the S&P 500 Index by itself never had a 59 percent gain in the follow-up years of this study, there were two years – 1954 and 1958 – when the average return of these four asset classes exceeded 59 percent. Accordingly, a full recovery in 2009 would not be unprecedented.

I see two important lessons here: First, based on nothing more than market history, there is reason for hope. Second, investors who diversified within the U.S. stock market have usually done better than those who didn’t.

The final lesson, implicit in this whole study, is that the gains of subsequent years went only to investors who were in the market when those gains occurred. In 2009, the third quarter proved to be particularly rewarding to stock investors. If you were invested in that period, you may have reaped those rewards. But if your money was on the sidelines while you waited for the market to feel “safe,” you didn’t.

I’ve said it before and I’ll probably say it again: Investors get paid for taking prudent, calculated risks.


Paul Merriman is founder of Merriman.

Note: Returns cited in this article do not reflect any adjustments for inflation, management fees, taxes or rebalancing. Sources: Dimensional Fund Advisors, Morningstar Inc.