The first half of 2023 is over, and the performance of the US stock market had been exceptionally strong. In contrast to 2022, where defensive sectors such as staples, utilities, and healthcare dominated, this year, we witnessed a shift towards cyclical sectors, particularly technology, communications, and discretionary stocks. In case you are not aware, technology as a sector has recorded an impressive gain of over 40% this year. However, if you look more broadly, the recoveries are far from evenly distributed. The dispersion is wide. Defensive sectors were flat or down slightly this year. Energy, the top sector in 2022, also fell into the red as the Covid-19 pent-up demand subsides and inflation slows.
What's Next For 2H 2023 (2nd Half 2023)?
So where are we going from here? Will the market correct, pause, or continue this relentless rally?
Now, those who knew me well know I don't try to predict market directions. That is why I pursued a multi-strategy approach using systematic models. But out of interest, I did a short quantitative study looking into the 2H performance of the S&P 500 from 1928 to 2022 to see if there are any interesting patterns to be found. I also break down the 2H performance respectively into 3Q (3rd Quarter) and 4Q (4th Quarter). But do take note that I am using the S&P 500 price index data direct from Yahoo Finance, so dividends are excluded from these data.
Let's look at the findings.
What are the chances the US stock market delivers a positive 3Q, 4Q, and 2H?
When we look at the 3Q, 4Q, and 2H performance of each year from 1928 to 2022, their chances of delivering a positive return stood at 60%, 74%, and 67% respectively. But if we look only at scenarios where the 1H is positive for the year, which is also the case we are at now in 2023, then there are notable changes. In general, a positive 1H suggests a higher probability of a positive 3Q, 4Q, and 2H except when 1H is exceptionally strong. When stocks gained more than 15% in 1H, the probability of 2H continuing to deliver positive returns drops to 50%. And we can also see from here that 4Q has a significantly better chance of delivering a return greater than zero than 3Q across all the scenarios.
What are average stock market returns during 3Q, 4Q, and 2H?
The average return for 3Q, 4Q, and 2H without any preconditions tied to its 1H performance is 1.3%, 2.8%, and 4.1%. But again, if we restrict this to scenarios where 1H is positive, the same pattern is observed. The average return rises for most of these scenarios if the 1H is positive. However, if 1H is strong and its gains exceed 10%, then the average return for 3Q, 4Q, and 2H starts to slide. In cases where the 1H delivers more than 15%, the average return of the 3Q even dips into the negative zone. And in line with what we observed earlier, the average return for 4Q is significantly higher than 3Q for all scenarios.
Based on the first set of findings, it suggests a 50-50 chance of 2H 2023's returns being positive or negative. That isn't really that helpful. But if you zoom in on the quarters, then Q4 seems a better bet than Q3.
How Does Each Month of The Year Perform?
Let's delve into even finer resolution by looking at the month of each year and see how each performed. This is without any preconditions tied. For each of the 12 months in a year, we compute their average return, volatility, and probability of that month delivering a positive return using historical S&P 500 data from 1928 to 2022. Then we compute the Sharpe for each month by dividing its average return against its volatility. Sharpe gives us a proxy risk-adjusted performance for each of these months.
As it turns out, September comes in at the bottom while December takes the top crown. So this explains from a number perspective why 3Q is worse off than 4Q.
Making Sense of The Data
This is a purely quantitative study for information and there are serious limitations here. The sample size is not large to begin with so we can't establish significance with these results. A few coincidental tail events can be all that is needed to skew these performances and change the findings. Macro factors are also not taken into account and markets do evolve over time which may render old seasonal behaviors obsolete. For example, if the Ukraine-Russia war escalates into a wider scale that drags other nations in, or a full-blown systemic banking crisis develops, things can turn ugly.
So at the end of it all, we can't say with any confidence where the US stock market will head from here. The best bet is still to diversify across different assets and strategies and sticks to what works for you.
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