May 2nd, 2011

Reversion to the Mean – Redux

It’s been quite some time since I visited the “reversion to the mean” chart that was so useful in picking the Financial Crisis Crash bottom in 2009 (see May 1, 2009). There’s no better time to revisit it than at a month end. Let me update that chart for you; I think it’s truly amazing (click on image to enlarge):

Since 1939, the stock market has risen at an average annual rate of 7.5% irrespective of recessions, wars, crashes, crises of one sort or another and rising or falling interest and inflation rates. Given this 7.5% average annual growth rate, the market has fluctuate within a fairly broad channel that is bounded 44% above and below that average growth rate.

Even though the market has undauntedly risen over this 72-year history, it has suffered through two “secular bear” (circled) during which time it attempted by failed to cross above two different resistance levels for more than 14-15 years. The first was during the 1970’s at and S&P around 80-110 and thirty years later, beginning with the Tech Bubble burst at around the 1000-1500 level.

At the depths of the Financial Crisis Crash, the market closed February 2009 at 735.09, just below the lower boundary then around 786.95. If there was any validity to the concept of reversion to the mean then at 1405.26 then the bottom to the Crash was near. Actually, the bottom was reached on March 9 when the S&P 500 hit 666 and quickly rebounded.

Since March 9, 2009, the market has experience what many observers believe is an incredible advance. In fact, one reason the advance has been so remarkable is because the decline that preceded was so dramatic. In May 2009, as the advance began, I speculated what the market might do if the exact same trajectory that occurred coming out of the 1970 secular bear market were repeated coming out of the current secular bear market. This is an extrapolation based on superimposing the market’s 11-year action in 1975-86 onto 2009-2020, not a prediction. The result is disappointing for the short-run (2011-2015) but hopeful again in the long-run (2015-2020):

Following this track literally means that the market could be heading into some murky water. We may soon stall out, retreat again and not see the current level again until sometime in 2013. If the recovery time frame over which the economy and the market took to come out of the 1970’s secular bear market were followed precisely again, then a new market high won’t be seen until around the beginning of 2015.

I have no idea and care little today to know what underlying fundamentals will be used to explain in the future the market’s then behavior. “Reversion to the mean” merely establishes the boundaries within which the consequences of all these underlying dynamics might ultimately be realized.

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