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Regression To Trend: The Only Certainty
- Written by Doug Short | Tuesday, April 03, 2012
ADVISOR PERSPECTIVES / DOUG SHORTApril 2, 2012
Doug Short
About the only certainty in the stock market is that, over the long haul, over performance turns into under performance and vice versa. Is there a pattern to this movement? Let's apply some simple regression analysis (see footnote below) to the question.
Below is a chart of the S&P Composite stretching back to 1871 based on the real (inflation-adjusted) monthly average of daily closes. I've using a semi-log scale to equalize vertical distances for the same percentage change regardless of the index price range.
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 1.72%.
The peak in 2000 marked an unprecedented 5% overshooting of the trend — nearly double the overshoot in 1929. The index had been above trend for two decades, with once exception: it dipped about 10% below trend briefly in March of 2009. But at the beginning of April 2012, it is 47% above trend, up from 44% at the end of the previous month. 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 around the 945 level. If the index should decline over the next few years to a level comparable to previous major bottoms, it would fall to the mid 400s.
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