Friday, August 20, 2010

Stock Market Risk Analysis

The following chart shows the Dow Jones Industrial Average adjusted for inflation (July 2010 dollars). It does not include dividends.


Click to enlarge.

The data is plotted on a log chart so that constant exponential growth is seen as a straight line.

It is an enhancement of a chart that I created about 6 years ago. That one wasn't adjusted for inflation but offered similar results.

The exponential trend line in green uses the low in June 1932 and the low in July 1982. The exponential trend line in yellow uses all of the data. The exponential trend line in red uses the high in August 1929 and the high in December 1999.

As a side note, I think the yellow line probably deserves to be parallel to the red and green lines. It's being tilted higher by our recent bubbles. I'm not adjusting for it though. I'm simply pointing it out.

Here's what the data looks like on a linear chart.


Click to enlarge.

Here are my conclusions.

If nothing has changed and we can assume all three long-term trends are therefore still in place then...

1. The average inflation adjusted fair value was 9,461 in July.
2. The potential downside risk was 3,106 in July.
3. The potential upside reward was 17,663 in July.

Let's assume that 9.5% unemployment, the lack of job creation for a full decade, and trillion dollar deficits don't constitute changes. They are just bumps in the road so to speak. Would it still seem rational to think that the DJIA would be trading above its average long-term fair value though?

What if things have changed? What if it really is different this time? Then what?

I'm retired. I exited the stock market in 2004 at levels slightly above today's levels. I have no desire to come back unless I see a suitable bargain that can reward me for the risk I'd be taking. As seen in the chart, the lows of 2009 were clearly not sufficient to lure me back. They weren't even close to the green line. Today's levels have no chance.

I'm perfectly fine riding this storm out in TIPS and I-Bonds, much to
the dismay of Jeremy Siegel.

Source Data:
Yahoo: Historical DJIA
St. Louis Fed: CPI

13 comments:

Stagflationary Mark said...

Here's a bonus thought.

I find it interesting that 1929 and 1999 both end in "9". Is there some sort of odometer turning over euphoria? Those were the inflation adjusted high points.

1932 and 1982 both end in a "2". 2 must be a depressing number. Those were the inflation adjusted low points.

2012 also ends in a "2". I enjoyed the movie. Sigh.

I'm not into numerology. I just find it interesting trivia.

Stagflationary Mark said...

I said that I exited the stock market in 2004 at slightly above these levels. I was actually talking in nominal terms. In inflation adjusted terms, I exited directly between the yellow line and the red line in the charts. In hindsight, no complaints!

watchtower said...

Mark

Your charts rule!
They certainly help me to get my mind around this stuff, and I need all the help I can get : )

This is off topic but have you seen this story about Greece that was in Spiegel?

Entering a Death Spiral?
Tensions Rise in Greece as Austerity Measures Backfire


"Everything is getting more expensive, I'm hardly earning any money, and then I'm supposed to pay more taxes to help save the country? How is that supposed to work?"

http://tinyurl.com/2e3hqog

Stagflationary Mark said...

watchtower,

Thanks!

I did see that. It prompted me to check out the following.

Greece Inflation Rate

watchtower said...

So are you thinking that Spiegel leaned a little to heavy on the 'doom and gloom'?

Because 5.5% from your link (although bad enough) doesn't seem like end of the world type of inflation to me (but then again, what do I know).

Stagflationary Mark said...

watchtower,

Not necessarily. A 5% increase in their inflation rate in just one year is plenty doom and gloomy to me, especially if you don't know where it is headed next.

That's especially true if you were an unemployed worker in Greece watching those prices rise as your income dropped.

My main concern was how much damage I might be taking in inflation protected treasuries if that happened here.

German Government Bonds Post Third Weekly Advance

Greek 10-year bond yields climbed 30 basis points to 10.55 percent.

Ouch. I'm not sure how much of that is default risk and how much is inflation risk. I'd have protection against the latter but not the former obviously.

In theory, I'd pretty much be completely protected (other than the taxation on the inflationary gains) if I held until maturity and our country did not default outright.

watchtower said...

Thanks for clearing that up for me, much appreciated.

Anonymous said...

>>I find it interesting that 1929 and 1999 both end in "9". Is there some sort of odometer turning over euphoria? Those were the inflation adjusted high points.

1932 and 1982 both end in a "2". 2 must be a depressing number. Those were the inflation adjusted low points.

2012 also ends in a "2".<<

I think you are right on with your bonus observation--can't say we will make it all the way to the green line, but we can dream. Your chart exhibits the lower highers and lower lows that CNBC, etc. would not like us to know about.

Stagflationary Mark said...

Anonymous,

Your chart exhibits the lower highers and lower lows that CNBC, etc. would not like us to know about.

It would be fun to try, lol.

I'd love to be given the chance to say the following.

"The yellow line represents the average. Unfortunately, the only way an average value makes sense is if you spend roughly the same amount of time below it as you do above it."

Anonymous said...

1) If we had let banks fail, do you think we would have hit the green line? I think so. A sharper recession, but with a better chance to come back as debts got discharged via bankruptcy of companies and people.

2) Too much debt requires debt cancellation and the people who lent the money taking a hit. For Greece, that means all of Europe's banks go kaput. Sounds like European heavy regulation of banks is not a good answer since it created suicide scenarios. Our banks are insane, but how did France and Germany allow their banks to become worth more than their own GDP several times over?

Coba

Stagflationary Mark said...

Coba,

I think we'll come close to that green line one way or another.

In order to prevent it, the government would have needed to create actual prosperity.

Deflation got us there in the 1930s. Inflation got us there in the early 1980s.

I feel we're trying to combine the two eras right now. Deflation and inflation are cancelling out to some degree, but the unemployment of both eras is not.

Anonymous said...

>>"The yellow line represents the average. Unfortunately, the only way an average value makes sense is if you spend roughly the same amount of time below it as you do above it." <<

Good point----with the demographics and massive hedge fund and pension liquidation that would accompany the next major dowdraft, we may be hard pressed to reach the yellow line, ala 29-49. Every time there is a rally, there would be plenty of selling to "almost breakeven."

Stagflationary Mark said...

Anonymous,

Here's anecdotal evidence of the demographics.

I'm 46 and technically a baby boomer. I liquidated all of my stocks in 2004. Unless prices become extremely cheaper, it is unlikely I will ever return.

Most of my nest egg now sits in TIPS and I-Bonds. I am a net seller of those too from here on out, if only to pay ongoing expenses.

I'm also a net seller of houses. I own one free and clear. I can't say when I will sell it, but I will at some point. It could be 10 years from now. It could be 30 years. Who knows?