October 11th, 2008

The Magic Number is Actually 7.5% per Year

Brett Steenbarger at Traderfeed referenced an interesting chart of the S&P 500 showing a 10% drift pattern. Brett writes:

Henry Carstens has posted an interesting chart that captures a 10% “drift channel” in stock market prices that reflects the long-term growth rate in equities as identified by the Dimson et al research. What is apparent from the chart is how far above that trend line we have risen in recent years. Henry opines that this unusual rise is attributable to the introduction of high leverage into markets via investment banks and hedge funds. With the credit crunch, we’re seeing a massive unwinding of this leverage, which is returning us toward the “fair value” represented by the drift channel. Should we overshoot this channel to the downside, that might constitute a measure of longer-term investment opportunity.

I have been watching the same trend and actually included an earlier version of the following in my upcoming book, Running with Herd:

My monthly data goes back to 1939 and shows an 7.5% long-term growth rate (before dividends) in the S&P 500 Index over the past nearly 70 years. A band of 44% above and below the regression mean bounds the Index throughout the period and contains the Bull Market of the 1950-60’s, the secular Bear Market of the 1970’s and the Bull Market of the early 1990’s (except for the tech bubble leading up to Y2K). Interestingly, all the Bull and Bear Markets prior to the Tech Bubble, grew at either the upper, lower or midpoint at the 7.5% rate.

Here’s what I all this means for us today? The good news is that after last week’s collapse, the Index came within 6% of the bottom boundary (intra-day 839 low vs. 789) boundary); we should be near very the bottom. The bad news is that projecting forward to the end of 2009, the lower boundary increases to only 858, or still below Friday’s close.

There will be bounces but, in all likelihood, it will be a long time (several years) before the Index touches 1400 again. Unfortunately, the “buy-and-holders” are going to feel extremely frustrated. Market timing will be extremely important. You’ll have to trade gingerly taking advantage of recovery moves. You’ll have to be patient and not expect a robust Bull Market to return anytime soon. Shed poor performing stocks and, as market weakness appears, become defensive to conserve your capital.

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