Why Stocks Could Rally 20% in 2018

The market seems to only go up now. The year 2017 is only the second on record since 1929 that the maximum drawdown on the S&P 500 Index (SPX) was less than 3%. Thinking about that, if you had bought and then sold at the worst possible times last year,you would have lost a measly 2.8%. Stocks don't look to be slowing down, either. The S&P 500 is already up 6% this year, but can this continue? This week, I'm looking at what happens after calendar years in which investors may have forgotten what it's like to lose real money.

Stocks After Banner Years

Using closing prices on the index, the table below shows the years with the smallest drawdowns on the S&P. Only 1995 had a smaller maximum drawdown than last year; therefore, if 1996 is an apt comparison to right now, then investors will be very happy. The S&P 500 went up more than 140% over the next four years, for an annualized return of nearly 25%, before the tech boom finally topped out. So, even after a full calendar year of only new highs, it does not mean a pullback is imminent.

However, such a solid year does not always lead to outsized returns going forward. The next table summarizes the S&P 500 returns following the years listed above. Stocks tended to struggle over the next six months, with the index averaging a slight loss, and just half of the returns positive.

In other years since 1950, the S&P averaged a 4.57% return in the first half of the year, with over 70% of the returns positive. After these slow starts, though, stocks seem to recover some. The full-year returns following small-drawdown years is close to the full-year returns during other years -- at least when looking at the averages.

Stocks Could Rally 20% This Year, If History Repeats

Below is a chart showing the returns of the subsequent years from the list above. I also included this year so far, alongside a line showing the average. The returns are wide ranging. The S&P 500 fell more than 25% in 1962, before recovering some to finish the year down just over 10%. So, it's not implausible for this market to take a turn for the worse. However, two of the years finished with gains of more than 20%.

Of these years, 2018 is off to the fastest start yet. The SPX is up over 6%, and we're not even through the first month. The only year comparable to that is 1996, when stocks reached a 6% gain by mid-February. It's good news if this year continues that trajectory, because in 1996, the index ended up 20% on the year.