The Good, the Bad, and the Ugly

by Chris Geerlings, Caiman Research & Analysis| February 26, 2009

Sometimes, a picture really is worth a thousand words. So I do not even need to use that many words to describe this chart that shows the S&P 500 index from 1965 to the present, adjusted for inflation. * The good: Stocks are finally “reverting to the mean”—in this case, the average price level of nearly a half-century, represented by the horizontal line. This means that stocks may finally be approaching fair value.

The bad: While the mainstream media perspective is that we are at an 11-year low at 1997 levels, the worse news is that this does not take inflation into consideration. With inflation factored in, we are actually at 1995 levels—a 13-year or 14-year low.

The ugly: Now that stocks have fallen this far, it is possible that they will bounce. But it is more likely, in my opinion, that they will overcorrect, like a pendulum, swinging further below the line representing average. If stocks were to drop 20 percent below the average line (not an unreasonable scenario) it would be a return to levels not seen since the 1980s, when adjusting for inflation. Further, to the extent that the CPI understates inflation, current levels should appear even lower than they already are.

And while the inflation adjustment admittedly makes present circumstances seem more dismal, it does give us an added measure of truth. Because even if stocks are about to bottom in nominal terms and begin to rise, if that “bottom” is a result of inflationary bailout money pouring into the economy, then this chart will not be fooled. It will show the index tracking lower, not higher.

The S&P 500 chart clearly shows a double top—the first bubble is associated with the technology boom; the second bubble reflects the (failed) attempt to reflate the first bubble with low interest rates and home equity extraction. But it also suggests that something extraordinary occurred around 1995. At that time, the S&P 500 began a practically vertical ascent, because nominal values were heading higher at the same time that CPI inflation was falling lower. What happened? Liquidity. As seen below, the M3 money supply commenced a similarly rapid ascent at around the same time in 1995:

So, all this having been said, what can we expect going forward? The answer to the question of whether we should expect S&P 500 values to remain above or below that pink line depends upon what we expect future conditions to be like. While no one can say for sure what the future will bring, it is my opinion that we are not headed back to boom conditions anytime soon. If and when liquidity does return, it is more likely to be put towards savings and debt reduction (deleveraging) than back into speculation. Ultimately, this would be for the long term good of the economy. But it would be bad for stocks in the short term, which likely means that stock price levels would remain below the average line for some time to come. One caveat: If inflation heats up sooner than expected, speculation may come back as investors become wary of cash. While this "speculation" would unlikely apply to the market as a whole, it could target specific sectors. This will be discussed in more detail in a future column.

* The top chart was created by simply dividing S&P 500 levels by the CPI and multiplying by 100. The CPI number, available from the Bureau of Labor Statistics, is calculated using 1984 price levels based at 100.

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Chris Geerlings | Caiman Research & Analysis | Email

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