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January 23, 2009

More "regression to mean" info

On Monday, I referenced a chart showing the market is currently priced some 40% below the long-term trend line that has been established over the past 200 years. It turns out, that chart is by no means the end of the story when it comes to plotting the market's historical path and what that means for the market's future direction as it "regresses to the mean" (i.e., moves back towards that long-term "normal" trend line).

Without going into all the details I've looked at this past week, this alternate site does a nice job of bringing out a couple of the key issues with these long-term trend analysis pieces. If you look at the two charts on that page, one shows the market currently right on the trend line. Presumably this would mean there could be plenty of downside still ahead. But the author explains that if you strip away changes in the way "official" inflation has been calculated since 1982, you get a trend chart that looks very similar to the one we looked at earlier in the week.

These charts raise a couple of issues. One, these charts start in 1871, whereas Monday's chart starts around 1800. Two, the inflation measurement obviously plays a big role in how these charts turn out.

It seems pretty clear that the starting point of the period measured makes a pretty significant difference in these long-term trend lines. But is the longer period necessarily better? Instinctively it would seem so, but the market was pretty different way back in 1871 and earlier (stocks were much less widely held, much more expensive to trade, plus a hundred other differences we could name). And it's a bit surprising that something as seemingly small as the changes to the official inflation statistic in 1982 would make such a huge difference in our conclusion.

Bottom line: take all these studies with a grain of salt. They do give us some interesting information to mull over, but it'd be pretty easy for us to see whatever we want to see in these charts, whether good or bad.