“Most of your investment returns come as a result of the 10 best days, so you should always be fully invested in the market.” Chances are you might have heard this before. Yes, being fully invested at all times is a valid argument. The surprise, however, is that it’s not true in the way that most think it is.
The first mistake in this saying is that it does not account for the timing of the 10 best days, nor the concept of achieving the highest possible returns with the least amount of risk.
That is why Countach Research took a look at 85 years of trading activity, examining the market closes of more than 20,000 days of US stock market trading. We came up with three key conclusions based on this research.
Reason #1: it’s almost magic how the worst and best days near perfectly equal each other out
In 85 years, there are around 2,000 days with closes above 1.2% and around 2,000 days with closes worse than -1.2%. Although the strength of closes differs by a little, in the end, it evens out near perfectly. The first conclusion we can draw from this is that the best and worst days even each other out near perfectly. In fact, relating to the original statement above: if investors didn’t have any positions during the 25 best and worst days, they would have outperformed the market. That is because the actual gains are made in the boring periods.
Now we understand that actual gains are found in times of low volatility and that the periods of high volatility add up to nothing.
Reason #2: It’s all about the timing of the market trends.
The timing is just as important. We can not predict whether tomorrow will be an up or down day, but we can look at timing and trends. When it comes to timing, most big one day gains came right after big one day losses. This is not a prediction that a big down day will always be followed by a big up day, but it does tell us that the high volatility occurs in short periods.
The stock market consists of fast, large and dramatic downtrends, and long and boring uptrends. As stated, most big one day winners are during these downtrends. We have also learned that the big winners and losers equal each other out. What that means, is that you’re exposed to more volatility while making lower returns during the downtrend periods, which are the periods that frequently include those “10 big up days” too.
Reason #3: Surprise! The S&P is reaching new highs today is, so tomorrow we might have lower-than-usual volatility
This leads me towards my third point, and that is the market reaching new highs. The S&P 500 is making new highs on multiple occasions lately. In fact, at the start of 2018 we predicted a big correction followed by the S&P reaching new highs above 3,000 (pictured below). Though the timing was a few months early, this turned out accurate.
The S&P reaching new highs worries a lot of investors, which is understandable given a lot of economic factors that are in play right now. From a statistical point, we can examine how reaching new highs has generally been responded to by the market.
The S&P reached new highs more than 1,000 times in the last 80 years. These new high days were followed by further gains the next day an average of 56% of the time, while the market made gains 53% of the time without new highs the previous day. Throughout this same period, the S&P increased by more than 2% only 3 times (on average), while it happened 4 times as often during a normal market.
The standard deviation during the off-peak market is 0.965%, and during the new high market is 0.611%. In simple words, volatility rises when the market is off the peak. Volatility is lower and an upcoming day of gains is more likely if the market closed at a new high.
The one idea to take away
If you will take one idea from this article, it is that returns improve and volatility is reduced when you’re invested in uptrend markets, and that volatility, in fact, is lower when reaching new highs.
Please keep in mind that trend following of course does not protect against a black swan event and that the market can always crash at any given moment. Those who are fully invested can look into using options as tail risk insurance.