The S&P Express: Off The Rails or on Schedule?

Is the stock market over-valued? Are recent ups and downs the warnings of a weak future stock market? Can you overcook frog legs? Stockholders want to know answers to these questions.

Trying to forecast the future direction of the stock market is more impossible now than ever. So I am giving up on that and will try to explain why below. It is perfectly okay to punt on such things. Sure, there are snake oil salesmen who will forecast quite assuredly on any day at any time. But as they say – you gotta know when to say when. This stock market is wandering like an office worker on Tuesday night in Gangnam after one too many Soju.

I am going to use the S&P 500 index for my discussion below. I could have used any other major stock index and come to the same conclusions. Essentially these indices track stock prices of the largest American firms. They are measures of “da market”. The S&P 500 tracks the 500 largest US companies.

Today’s blog is more about the data and less about the theory.  I usually like starting with theory because it makes sense. For example, a stock is supposed to measure the value of the company. If investors believe that a company is doing much better these days and it has higher profits to prove it, then more people want to buy that stock. 

They buy it because they anticipate the company might issue dividends to the stockholders or they think the price will rise higher in the future. As they buy more of that stock the price often rises until the point at which people feel the price is high enough relative to its rewards.  If we are looking at the S&P 500, it often rises when the whole business sector is doing better – meaning more dividends and higher expected stock prices across the largest and most representative companies in America.

Stock prices may rise for many reasons. You might be unhappy when your local bank lowers the interest rate on your saving account to .00003%. So you take money out of that account and buy a share of the Jack Daniels Company. Any local or global event that induces investors to redirect assets away from other investments and into US stocks can cause the S&P 500 to rise.

That’s the end of my maco-finance lecture. The reason for reviewing some of this theoretical minutia is that there is plenty of difference of opinion about the future course of the stock market based on theory. There is ALWAYS plenty of difference of opinion among theorists about the market. There might be more now than usual but it seems to me the overpowering case for stock price uncertainty is not the theory. I think it is in the numbers.

Let’s suppose you have a friend and his name is Mabby. Let’s suppose Mabby weighed 150 pounds for the last 17 years. Knowing nothing about Mabby you might be quite confident that next December Mabby would weigh about 150 pounds.  Now supposed you had another friend named Abbmar. Abbmar weighed 150 pounds a year ago. Last December he weighed 350 pounds. In March he weighed 200. What is your best guess as to Abmar’s weight in three months? I am guessing you would have a lot of uncertainty about that prediction and you wouldn’t bet a lot on its accuracy.

That’s the way I feel about the S&P 500 right now. Most graphs of the S&P compare its value today to what  is was recently. Most geniuses compare it to a low point in 2009. Since then it has oscillated quite a but but the main story is its upward trend. But that little bit of history is very misleading since it looks at today relative to a recent low value.

So I decided to look at the S&P 500 going back to when it was just a little pup in 1950. I deflated all the monthly values for general inflation because you cannot compare apples and oranges or something like that. Then I graphed it. I could have calculated a bunch of really cool statistical numbers but sometimes just looking at the graph is enough. See the Chart below. (Note: The S&P 500 value today is approximately 2100. But when you deflate it by a CPI value of about 234, you get a number more like 8.)

·        From 1950 to about 1968 the real S&P 500 rose from a value of about 0.75 to about 3. The line looks pretty smooth despite there being plenty of ups and downs over those 19 years.

·        From the end of 1968 to the middle of 1982 the market was generally declining from about 3.0 to a low value of about 1.0. So we had about 15 years of a downward trend.

·        Then we had another time period of S&P expansion with few major downturns from 1.0 in 1982 to a value of almost 3.3 in early 1994. It took about 13 years but we got back to an old peak value of around 3.

·        In short we had three long cycles from 1950 to 1994 and the market value rose from about 1 to 3 in those 45 years.

·        Then it gets really weird. The S&P started drinking too much JD.  The real S&P 500 almost tripled from about 3 in 1994 to almost 9 in early 2000. The market dove from that peak of near-9 in early 2000 to just above 4.5 in early 2003. It reversed and went to above 7 at the end of 2007 and then to about 3.5 at the end of 2009. It is closing now again on 9. Are you seasick yet?

What can we say? First, we used to have long term trends in market direction that lasted for a decade or two. Now we have significant directional changes that last for at most a handful of years. Second, with those rapid direction changes go large percentage changes. A statistician might say that the standard deviation or variance has increased. Others might say the data is much more volatile lately. No matter how you say it – the market seems very unpredictable right now. 

Finally, even with all this craziness – it is not  easy to know what the most relevant previous peak is. The market hit 9 twice so maybe that is the new peak. But those peaks came after some unique situations and may have involved bubbles. One recent peak was squeezed between the 9s – of about 7.5. Today we are well above that one. There is also the previous high level of about 3. If that is the relevant peak then the market has a lot of room to fall in the future.

Being at or near the highest of the past peaks makes it hard for one to forecast anything good for the future value of the real S&P 500. So I did one more thing. I drew a line of constant 5% real growth from the peak value of 3.0 in 1994. ( See the red line on the chart below.) Today that 5% constant growth line produces a trend value of about 9.2 for the real S&P 500. Thus if we just erased a lot of crazy ups and down of the last 22 years and replaced all that with steady real growth of 5%, we would be at a value similar to what we experienced last week in the real S&P 500. In one year, it predicts a S&P 500 value of near 9.7.

So there you have it. Numbers don’t lie or do they? Much of my analysis suggests we could be in for a significant decline in the stock market. A trend analysis suggests the opposite. Of course, much depends on the theory. Are we really back to theory again?