(Bloomberg) -- Equity bulls limped into 2023 with positions trimmed, hedges firmed and much bubble excess in the rearview. They also came in with an unusually big chunk of their long-term gains intact, and are watching those spiral back up in a January rally that has defied most predictions.

While last year’s 20% hit to the S&P 500 was the worst since the financial crisis, it did little to chip away at the bounty laid up by buy-and-hold faithful. That’s evident in the S&P 500’s annualized return over the past 10 years, which stood at 11.7% even at last year’s trough. While down from 16% from a year earlier, the gain was still above the average of 10.6% over any decade since 1927, and beat all but four long-term returns at the end of 13 bear markets.

Statistically speaking, it’s a distinction of limited meaning — long-term returns now are far from unprecedented, and the 6% rally since New Year’s shows anything can happen over short horizons. But to a category of analysts who hold that major shifts in Federal Reserve policy usually spell doom for fat seasons in equities, the robust returns of the past decade are a lingering vulnerability given their impact on sentiment and valuations.

“This one in particular is challenging because we are in an environment where the Fed is facing down inflation that it hasn’t had to deal with for more than 40 years,” said Jake Jolly, senior investment strategist at BNY Mellon Investment Management. “This is arguably a pretty significant regime change.” 

The shift in Fed policy last year wrung out excesses brought on by unprecedented government spending and central-bank largesse, sending the Nasdaq Composite index tumbling 33%. But an 11% surge to start the year, powered by bets that tech earnings will withstand an economic slowdown, isn’t sitting well with Fed officials who view market gains as diluting tighter policy. The Fed is expected to downshift the pace of its rate hikes next week, and may well reiterate its warning to investors about “an unwarranted easing in financial conditions.”

Another rousing week on equity markets sent the Nasdaq higher by 4.3% for its fourth straight weekly gains, the longest winning streak since August. The S&P 500 advanced 2.5%, with the January surge pushing the rolling 10-year gain even further above the long-term average. 

Why consider returns over years or decades? While day-to-day swings get all the press, they’re irrelevant to the overwhelming majority of investors who view the stock market through the lens of retirement savings or putting kids through college. Decade-long returns evolve at a glacial pace but are a significant input into how investors feel about their portfolios.

Even with its rout, last year was the fifth in a row that the S&P 500’s annualized 10-year return exceeded 10%, testament to the power of the rally that came before it. In a sign of how big the post-crisis bull market was, the index could go nowhere in 2023 and still be sitting with a 9.4% annualized gain over the 10 years through December. 

Stretches like this aren’t unheard of. The runup that cumulated in the dot-com crash of 2000 generated 19 consecutive years in which the 10-year rolling, annualized return was above 10%. The rally that began in 1950 did it for 16 years. 

While shorter than those, the latest run of above-average returns has pushed prices in the stock market to valuations with few precedents. At its all-time high reached just over a year ago, the S&P 500 was trading at 25 times earnings, a multiple that topped all but one bull-market peak since the 1950s. Should the Oct. 12 low in the S&P 500 hold, it will have been set at a valuation higher than nearly every bear market bottom over the same time period. 

Valuations are a poor tool for market-timing, but do hold clues about expected returns over longer periods. The higher they are, the worst investors have fared, generally speaking. One popular model, developed by Robert Shiller, uses cyclically adjusted price-to-earnings (CAPE) going back more than a century and then smooths the ratio out over 10-year intervals. Plotting CAPE against the S&P 500’s forward returns in the subsequent decade shows the two track pretty closely. 

The relationship was elaborated upon by AQR Capital Management in a 2012 study that broke down the equity index’s future performance based on a various range of CAPE levels. In that framework, the equity rally that pushed CAPE above 38 in November 2021 — a level that exceeded more or less all periods since 1871 save the dot-com era — was bound to lose steam. The impetus was the Fed’s policy shift. 

While CAPE has since fallen to 28, it is still high, sitting roughly 60% above the average. That’s a bracket that historically corresponded to the worst period of performance for the S&P 500: an average above-inflation return of just 0.5% a year during the ensuing decade. That compares with a gain of about 10% when CAPE stood below 11.

Such a valuation backdrop, along with a hawkish Fed, is why market prognosticators call the latest runup another bear market rally. Strategists at Wall Street firms from Morgan Stanley and JPMorgan Chase & Co. predict stocks will reach a bottom in the first half. Yet the downturns that came after the last two prolonged bull runs showed subpar returns lasting more than a decade.

“Valuations are going to be key to how we get out of the bear market,” said Quincy Krosby, chief global strategist at LPL Financial. “The past decade has been filled with unprecedented liquidity in the system. This is a painful unwinding of that.” 

There is no guarantee that the pattern will repeat this time, though the risk is something worth heeding for investors who remain eager to buy every dip after their success with the swift post-pandemic recovery. Retail traders, who repeatedly dived in earlier in 2022 when stocks pulled back, got burned, with all their profits made in the meme-stock rally wiped out. 

Rich valuations pose much less of a threat if corporate profits are able to catch up and eventually make stocks look reasonably priced. But earnings sentiment is souring. Even the ever-optimistic analysts are taking a knife to their profit forecasts. Projected earnings growth has turned negative for this quarter and next, according to data compiled by Bloomberg Intelligence. That’s down from double-digit growth seen back in June.

To Charlie Ripley, senior investment strategist at Allianz Investment Management, the 2022 bear market was mostly driven by a valuation correction into a higher interest rate environment. For the new year, he says, the focus will be about how badly the Fed’s efforts to slow the economy hurt corporate America’s earnings power. 

“The outlook for 2023 will likely follow a different narrative as input costs are harder to offset and the economic slowdown takes hold,” he said. “As such, lower expectations for earnings growth have the potential to be a headwind for stock prices.” 

--With assistance from Elena Popina.

©2023 Bloomberg L.P.