Thursday , 28 March 2024

February Update: How Mean Will the S&P 500’s Future Regression to Trend Be? (+3K Views)

About the only certainty in the stock market is that, over the long haul, over-performance turns into under-performance [ i.e. reversion to the mean or regression to trend] and vice versa [and depending on what data you use the stock market could be setting up for a MAJOR fall. How major? Read on!] Words: 840

So says Doug Short (www.dshort.com) in paraphrased comments from an article* reformatted and edited […] below by Lorimer Wilson, editor of www.munKNEE.com, for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Short goes on to say:

Is there a pattern to this movement [to the mean]? Let’s apply some simple regression analysis… to the question. Here’s a chart of the S&P Composite stretching back to 1871.

The [above] chart,  using a semi-log scale to equalize vertical distances for the same percentage change regardless of the index price range, shows the real (inflation-adjusted) monthly average of daily closes. The regression trendline drawn through the data clarifies the secular pattern of variance from the trend — those multi-year periods when the market trades above and below trend. That regression slope, incidentally, represents an annualized growth rate of 1.70%.

The Bearish View is that the S&P 500 is 45% Above the Regression Trend Line

The peak in 2000 marked an unprecedented 157% overshooting of the trend — about double the overshoot in 1929. The index had been above trend for nearly 18 years. It dipped about 9% below trend briefly in March of 2009, but at the beginning of February 2011 it was 45% above trend. In sharp contrast, the major troughs of the past saw declines in excess of 50% below the trend. If the current S&P 500 were sitting squarely on the regression, it would be hovering around 884 [or approximately 32% less the the current level of the index]. If the index should decline over the next year or two to a level comparable to previous major bottoms, it would fall to the low 400s [or – approx. 70%!].

The Bullish Alternative is that the S&P 500 is 40% Below the Regression Trend Line

A critical factor for the reliability of a regression analysis of stock prices over many decades is the accuracy of the inflation adjustment. The Bureau of Labor Statistics (BLS) has been actively tracking inflation since 1919 and has estimated inflation rates back to 1913 using data on food prices. In 1982, however, the BLS began incorporating changes to the Consumer Price Index (CPI), which is used to calculate inflation. These changes have resulted in much lower “official” inflation rates than would have been the case if the method of calculation had remained consistent.

At his shadowstats.com website, economist John Williams publishes an “Alternate CPI” employing the earlier BLS method. Here is a chart that illustrates the significant difference between these two calculation methods.

The change is astonishing. The adjustments to post-1982 data alter the slope of the regression and impacts the variance from the trend across the entire time frame, dramatically so in the last two decades. The slope drops from an annualized growth rate of 1.70% with official CPI to 1.37% with the alternate CPI. In this view, the S&P 500 has been below trend since the end of 2007. The 2009 bear market low saw the monthly average index price drop to 58% below the trend, which puts us in the territory of those secular market troughs. The current price is about 40% below trend.

Which Regression to Trend Analysis is Correct?

[You have to ask yourself] these two questions: 1. Are you bearish or bullish about the market? 2. Which is more reliable: the Bureau of Labor Statistics or ShadowStats.com? My opinion is that the optimum method for calculating consumer prices is probably somewhere between the revised BLS method and the historic method preserved by Williams. Ordinarily for a long-term regression analysis, consistency would be preferable, which may lend some credibility to the alternate CPI chart. However, government policy, the Federal Funds Rate, interest rates in general and decades of major business decisions have been fundamentally driven by the official BLS inflation data, not the alternate CPI. For this reason I think the bullish alternative is misleading. The more I study long-term economic and market trends, the less I believe this alternate-adjusted regression analysis.

Check back next month for another update.

*http://dshort.com/articles/regression-to-trend.htm

Editor’s Note:

  • The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
  • Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.
  • Sign up to receive every article posted via Twitter, Facebook, RSS feed or our FREE Weekly Newsletter.

Regression