The financial crisis of 2008 engendered severe declines in equity markets and economic activity around the world. Underscoring the severity of the crisis and the rising uncertainty about the future economic and financial landscape, the daily volatility of the U.S. stock market over the year approached levels last seen during the Great Depression.

The events of 2008 raise important questions about the markets and the economy in 2009:

• Given that the stock market is a leading economic indicator, what do its returns and volatility last year imply about the severity of the U.S. economic recession this year? In other words, how much economic "bad news" has already been discounted by the market?
• Do the exceptional levels of volatility witnessed during 2008 imply anything about the market's performance in 2009 and beyond? Similarly, how strong is the tendency for stock returns to "mean-revert"? Can investors learn anything from the past?

In this paper, we consult historical U.S. data as far back as the 1870s to examine the predictive relationship of annual stock market returns and their within-year volatility on future real economic growth. Specifically, we show that the returns and volatility of the stock market in any one year explain more than 50% of the pattern in real GDP growth the following year. Looking ahead, our analysis implies that the stock market's performance in 2008 has priced in an extremely harsh U.S. recession for 2009, one that would be approximately twice as severe as the deep recessions of 1974 and 1982.

We also evaluate whether trailing stock returns or volatility levels have any correlation with future stock returns over 1-, 3-, 5-, and 10-year horizons. Overall, we show that the level of market volatility in any one year has effectively zero correlation with future stock returns over both short- and longer-term horizons. We do find some evidence that stock returns tend to revert to their long-term mean over 3-year and 5-year horizons, although the correlation is low. A more significant (and long-recognized) relationship is found between current stock valuation metrics (i.e., price/earnings ratios or dividend yields) and future long-term returns.

Given end-of-2008 valuation levels, our analysis suggests that a reasonable "central tendency estimate" for the return of the U.S. stock market over the next ten years should be near the long-term average of 8%-10%. How the stock market may perform in 2009 is obviously much less clear and depends on a number of factors, including the success of various monetary and fiscal policies aimed at stunting the severity of the recession, the degree of risk-aversion among various market participants, and the expected future earnings growth of companies around the world. The profound uncertainty with respect to the timing and magnitude of a future stock market rebound underscores the time-tested benefit of maintaining a strategic and well-diversified portfolio allocation.

Introduction

The year 2008 was one of the most vicious—and volatile—years for the U.S. stock market in its long history, as illustrated in Figure 1. The financial crisis engendered severe declines in equity markets and economic activity around the world. An index of the largest U.S. stocks—the Standard & Poor's 500 Index—posted a -37% return for the 12 months. Returns across all market capitalizations and styles were markedly negative, with all stock sectors down more than 20% for the fourth quarter.

Stock market volatility in 2008 approached levels last seen during the Great Depression, as further illustrated in Figure 2. Historically, stock volatility has tended to persist, with high volatility in one year typically followed by high volatility the following year. Such periods tend to occur during (and often preceding) recessions.¹ This is one reason that the extreme volatility witnessed during 2008 has contributed to widespread alarm about the severity of the crisis and what it could mean to the global economic and financial landscape.

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