Personally, when it comes to stocks, I don’t find much value in so-called “technical analysis”, which is the analysis of charts. I prefer techniques such as fundamental analysis of valuation ratios, to decide whether or not I’m getting a bargain. But I always look at charts nonetheless, as one of many inputs into investment decisions. However, which chart is used can make a big difference to what an investor sees.
Stocks have wobbled this week due to uncertainty over the outcome of US-China trade talks. There have been plenty of dramatic headlines. But the reality is that, at a level of 2,870, the S&P 500 index is down just -2.6% since the high reached on April 30th.
It’s easy to get swept up in the immediate. I find it more useful to take a step back and look at the long view. Successful investing is a marathon, not a sprint. At least, if you try to sprint you’ll have to do it over marathon-type distances, which is impossible.
Reading market history is a great way to gain perspective on how things are today, what to avoid, or how to find the best opportunities. Every stock investor should read “The Great Crash 1929” by John Kenneth Galbraith. It will teach you a lot about the risks of leveraged investing, greed, fear, mob mentalities and much more. Another favourite of mine is “Tomorrow’s Gold” by Marc Faber. Despite the title, most of the book is about the past, and little is about gold.
Whilst reading such books is a great help, it’s also time consuming (although time well spent). For a quicker snapshot of history, long-term charts are a great tool. I love long-term historical market charts.
Below is a chart of the S&P 500 index of US stocks, or predecessor Composite Index before March 1957. It shows the index level since January 1928.
S&P 500 since January 1928
Looked at like that, it appears that not much happened until 1980, and then stocks took off like a rocket. It also looks like the ride was smooth for decades, but suddenly the price volatility went crazy after the late ‘90s. It also seems like the market is in a massive bubble right now.
But is that a fair view? Not really.
First of all, we need to adjust the index level for historical inflation. In the long run, company profits tend to move in line with inflation, and stock prices move in line with company profits.
Also, the aim of investing is to beat inflation over time, thus increasing the purchasing power of the investments. So it’s the real returns, above inflation, that matter. Since inflation rates can vary widely over time, it’s thus better to look at the stock index adjusted for inflation.
S&P 500 since January 1928, inflation-adjusted
This has already made the line less smooth, and changed the relative positions of the peaks and troughs. For example, 2007 is now below 2000, whereas before it was marginally higher.
But there’s still a problem. The line still goes nearly vertical in recent years, and the current index level looks like a bubble. In reality, this is still misleading.
To correct for this, we need to change the vertical price axis from a linear scale to a logarithmic or “log” scale. With a linear scale, the same physical distance between two levels on the vertical axis always represents the same number of points. With a log scale, the same physical distance between two levels on the axis always represents the same relative change, in percentage terms.
So here’s that same chart again, but with a log scale (and also adjusted for inflation).
S&P 500 since January 1928, inflation-adjusted, log scale
Suddenly the picture is dramatically different. Compare this latest chart with the first one. Now we can see that price volatility is nothing new. In fact, the market fell much harder (in real terms) after 1929 than it did after 2000 or 2007.
Also, the current level doesn’t look nearly so extreme. If stock prices went up at a constant rate above inflation every single year, that last chart would be a straight line rising from the bottom left to the top right. If you imagine that line in your mind’s eye, it’s possible to imagine that the current level isn’t actually far off the long-term trend.
But it’s such a long-term trend, since January 1928, that zooming could tell us more. After all, a lot has changed over the past century (and change).
Note least, the US dollar was pegged to gold until 1971, but has been a purely fiat currency since. Since these are completely different currency regimes, it’s fair to assume they lead to different distortions in markets (a long discussion for another day). So it seems sensible to focus on the fiat period after 1971 when looking at stock market trends. Forty eight years is still enough for most people in terms of long-term thinking.
Below is the chart for the S&P 500 since the peg was broken in 1971.
S&P 500 since 1971
This gives a similar picture to the earlier chart since 1928. It looks volatile in recent years and bubbly towards the end. But look how different it is once adjusted for inflation and using a log scale on the vertical.
S&P 500 since 1971, inflation-adjusted, log scale
That’s practically a straight line, at least to some of the builders that I know. Suddenly, 1974 and 2009 stand out as massive buying opportunities. The year 2000 is the only stand-out bubble. Whereas 2007 looks pricey but not crazy (at least, absent the financial crisis), and today looks more or less on trend. The sharp sell-off of 1987 – as it was seen at the time – is a mere blip.
So let’s zoom in a little further to see if things look different. Let’s take a look at the last 30 years, since 1989.
Here’s the unadjusted chart with the linear scale.
S&P 500 since 1989
But here’s the same chart adjusted for inflation and using a log scale.
S&P 500 since 1989, inflation-adjusted, log scale
Again, it’s a very different picture when you look at it from this “angle”. US stocks don’t exactly look cheap. But neither do they look way off the longer term trend of their returns above inflation. (Also, the year 2000 bubble is even more obvious.)
Put another way, now is unlikely to be the very best time to buy the S&P 500. However, over 10 or more years it’s highly likely to result in decent, above-inflation returns.
Over reliance on charts is not a good idea for investors. But looking at the historical record, through the medium of charts, helps us to gain perspective, especially when it comes to stocks.
Just remember to look at the right kind of chart when you do. And beware the people that present carefully constructed charts to prove a point.
Stay tuned OfWealthers,