Market Equilibrium
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Where Should the S&P 500 Index Be Today?
Someone asked me in 2001 if I thought the markets would ever recover from the then recent losses and return to normal. The truth is the stock market performance that we have experienced between 2000 and 2009 is normal. What we have been experiencing is what we call reversion-to-the-mean. And sometimes, as we saw in 2000-2002, it is indeed mean.
The following analysis makes these three assumptions:
- The average total return to the large-cap equity markets since 1925 has been approximately 12% per year, including dividends and capital appreciation.
- Since 1985, the average dividend yield has been 2.75%. We use a shorter time period for this component because dividends have become a smaller component of total return during the last 20 years.
- We should be able to use the difference of 9.25% (12.0% - 2.75%), as the expected annual capital appreciation of the US equity markets since 1985. On a monthly basis, this is approximately 74 basis points (0.74%) each month, compounded monthly.
We use the S&P 500 Price Index to represent the US equity markets. This index ended at 211.30 on December 31, 1985. Assuming the 74 basis points per month compounded monthly, at what value should the S&P 500 have closed on the last day of trading for the month on February 26, 2010?
Based on the Theoretical Index, the S&P 500 should have closed at 1,792 on February 26, 2010. It actually closed at 1,104 for a difference of -688 points. That is 38.39% below the expected long-run average Theoretical Index.
The most interesting part of this analysis is how well the market followed the Theoretical line until 1995. The curvature of the blue theoretical line is a result of compounding the monthly values.
For those economists that prefer their charts in the logarithmic scale, we provide the same chart rescaled accordingly:
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