The S&P 500 is trading at record highs and on pace for very stellar performance in 2024. Perhaps most enjoyable for investors has been the easy ride: The S&P 500 hasn’t fallen 10% a single time this year. Since 1980, the index has averaged an intra-year decline of 14%. But there’s been 19 other times when the index didn’t fall more than 10% all year. This lower than average volatility has usually been followed by less volatility the following year as well, but also lower returns. Let’s look at what 2024 might tell us about 2025.
What is a drawdown?
First, all investors should understand the term drawdown: A drawdown is a peak-to-trough decline during a specific period for an investment. For example, the S&P 500 is currently around 5,850. If the index fell to 5,557 in the coming weeks, the index would experience a 5% drawdown. Drawdowns do not end until the index reclaims the high which it fell from. In our example, even if the index did not go any lower than 5,557, it would still remain in a technical drawdown until it got back over 5,850.
Drawdowns are an important part of the investor vocabulary because they are guaranteed to happen. Invest long enough, and you are sure to experience some nasty drawdowns. In 2008, the S&P 500 experienced a 49% drawdown. We can define an intra-year drawdown as how much the index fell from a high during the calendar year. It’s imperative to note that drawdowns do not keep the market from posting positive returns. To the contrary, the market has posted positive returns most years, even while experiencing regular drawdowns.
The graph below shows every yearly drawdown since 1980, where the red dot represents the intra-year drawdown for that year, and the gray bar represents that year’s annual return.
What does 2024 imply for 2025?
We took the data above and grouped returns into two categories:
- Years when the S&P 500 saw a drawdown of less than 10% (like 2024 so far)
- Years when the S&P 500 saw a drawdown of 10% or more
We then took that year’s data and focused on the following year. Our aim is to see if a prior year’s drawdown tells us anything about the following year’s expected drawdown and return potential. What we found is that yearly returns are actually much higher when the prior year saw a drawdown of 10% or more. Meanwhile, yearly returns are lower on average in the year after a drawdown of less than 10%.
So, on a baseline level, we could say that because 2024 is on pace to be a “less than 10% drawdown” year, 2025 might see less upside. That’s not a guarantee of less upside, of course. But that framework can help shape our expectations, overall.
Digging deeper into the data
One other nugget we found interesting: you want to see volatility stay low. Meaning, if we define years of less than a 10% drawdown as a “low volatility year”, then you want to see low volatility in the following year as well. When a low volatility year was followed by a year in which a drawdown did exceed 10%, that year’s return was very poor. There’s been nine such years since 1980 that match the following criteria:
- Prior year saw a drawdown of less than 10% (like 2024 so far)
- Next year saw a drawdown of 10% or more
In those nine instances that match the above criteria, the S&P 500 averaged annual returns of just 2% and was positive 55% of the time. Moreover, those nine instances saw an average intra-year drawdown of 20%. So if the S&P 500 does experience a 10% drawdown in 2025, it could be a bad omen for the full year return.
On the other hand… when low volatility stayed low, returns were strong. There’s been ten such years since 1980 that match the following criteria:
- Prior year saw a drawdown of less than 10% (like 2024 so far)
- Next year also saw a drawdown of less than 10%
In those ten instances that match the above criteria, the S&P 500 averaged annual returns of 13% and was positive 90% of the time.
Admittedly, there is in an inherent flaw with using this information in real time because you never know how bad a drawdown will be once it starts. However, arming yourself with this information can help you mentally prepare for what might lie ahead. And so much of successful investing is rooted in not being surprised by what the market is doing. In addition, with Treasuries, Agency, and Investment Grade bonds yielding 4-6%, you have plenty of ways to diversify your risk heading into 2025.
2024’s been a calm market with lots of upside, but that may not be the best sign heading into 2025.
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