What happens to the stock market after a 20% down year? It's complicated

Published Fri, Dec 30 20228:44 AM EST

It's been a rough year. The S & P is on the cusp of a rare 20% annual decline. It's unusual for two reasons: It's a down year (the market tends to rise year over year) and the size of the decline (anything near 20% is an unusually large pullback). First, the bad news: this would be the fourth worst year for stocks since 1945, behind only 2008, 1974 and 2002. Wall Street's worst years (S & P 500, since 1945) 2008 down 38.5% 1974 down 29.7% 2002 down 23.4% 2022 down 20%? Source: CFRA Research Now, the good news: the market tends to bounce back in the year following losses. "Should history repeat (and there's no guarantee it will), the S & P 500 has a good chance of posting an above-average return in 2023," Sam Stovall, chief investment strategist at CFRA Research, said in a note to clients. The S & P has had down years 21 times since 1945 (27% of the time), but the following year has been up 81% of the time, with an average gain of 14.2%, according to Stovall. That beats a typical year, when the S & P rises 70% of the time and posts an average gain of 8.6%. In years where there are declines of 10% or more, as is the case with 2022, the returns are more muted, but the market is still up: the S & P rose in 73% of those years, climbing an average 7.8% in price. What should investors buy after a losing year? Should investors buy last year's winners or last year's losers? Stovall says the historic winning strategy is different following down years. "Following up years, history says that investors should stick with the four best-performing sectors, and 'let your winners ride' into the new year," Stovall said. "However, if the market had fallen, history recommends rotating from 'first to worst' by getting out of those likely defensive groups that held up best during the decline and rotate into those sectors that fell the furthest." That would mean rotating out of the best performing sectors: 2022 Sector Winners Energy up 57% Utilities flat Consumer Staples down 3% Health Care down 3% and into the worst performing sectors: 2022 Sector Losers Communication Services down 40% Consumer Discretionary down 37% Real Estate down 28% Technology down 28% Still, sector rotation is not a strategy for the squeamish. It produces only modest gains. Sector rotation: what happens after a down year? (S & P 500) Four worst-performing sectors: up 14.8% Four best-performing sectors: up 11.6% S & P overall avg gain: up 14.0% Source: CFRA Research Bottom line: Unless you have an iron stomach, buy and hold strategies are typically the best.