Many gamblers believe that after a long streak of a particular outcome, the likelihood of a different result has increased. For example, if someone were to flip a coin five times and in each instance the coin landed on “heads,” many would believe that the odds of “tails” on the sixth flip are better than 50%, in order to bring the sample in line with long-term averages. However, the coin has no memory, and the Law of Large Numbers doesn’t strictly apply to smaller data sets. The desire to seek balance can create a gambler’s fallacy where past results skew perceptions on what is likely to occur (or not) in the future.
This dynamic can play out in financial markets as well. The S&P 500 Index delivered 25% returns including dividends in 2024, the second year in a row that U.S. equities were up by more than 20% following 2023’s 26.3% total return. The gambler’s fallacy may lead investors to believe that the market is “due” for a bad year given a meaningfully lower long-term average annual return for the S&P 500. However, history shows that the market has typically continued to deliver solid (albeit more muted) returns in years following back-to-back 20% plus gains, with an average of 12.3% and positive returns occurring 75% of the time.
The strength of the current bull market has taken many by surprise, with the S&P 500 up 70.1% including dividends since the October 2022 lows. Perhaps even more notable is the lack of a -10% (or worse) correction during this period. Although this run may seem like an outlier destined for mean reversion and materially lower equity prices, history shows that this may not actually be the case. Since 1950, the S&P 500 has experienced nine periods that went even longer without a -10% correction, including four stretches that lasted more than twice as long as the current run. Put differently, the fact that the market hasn’t yet seen a correction in over two years doesn’t mean one is a foregone conclusion in 2025.
That said, 2024 ended on weaker note with the S&P 500 experiencing its second-worst month of the year, a sign that a period of digestion may be needed after previous strength. There are several potential catalysts for a pause, including investor complacency, higher rates/inflation and tariffs. Policy sequencing by the new administration may be one of the bigger hurdles in the near term, as visibility on the tariff front appears likely to emerge well before the green shoots from deregulation and tax cuts have time to sprout.
A separate concern comes from elevated market concentration, with the 10 largest companies in the S&P 500 comprising a record 38.7% of the benchmark. While this has the potential to be problematic at the index level, it also presents an opportunity for active managers who tend to do better when the average stock is outperforming. In fact, when the top 10 weights in the S&P 500 have historically made up an outsize share of the benchmark, the equal-weight S&P 500 has handily outperformed its cap-weighted counterpart over the subsequent five years.
Although the market could remain highly concentrated in the quarters to come, such as in December when the Magnificent Seven outperformed the equal-weight S&P 500 by 10%, history shows that mean reversion typically occurs around these levels of concentration. While in the past it has taken a recession to spark an inflection, broader earnings delivery after multiple years of superior mega cap earnings growth should lead to wider equity market leadership in 2025 with the laggards of this cycle (small cap, mid cap, value) catching up on a relative basis. Put differently, a market concentration mean reversion could begin to play out in 2025 due to fundamental drivers like relative earnings growth.
Jeffrey Schulze, CFA, is Director, Head of Economic and Market Strategy at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice. Past performance is no guarantee of future returns. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information.