By Rick Lehman
Stock market watchers are well aware that, while the direction in stock prices is ultimately guided by the underlying fundamentals of corporate earnings and the health of the U.S. economy, short-term events, concerns and perceptions cause prices to vary considerably above or below the long-term average.
In fact, it may surprise you how little the stock market's performance in any calendar year resembles the long-term average. When I analyze the annual performance of the Dow Jones Industrial Average from 1901 through 2011, the mean performance is about 7.1% per calendar year when dividends are excluded. During that 111-year period, annual performance varied between -52.7% and +81.7%, and in only six of those 111 years did the performance even land between +5 and +10%.
More than 70% of the time, annual performance was either less than zero or greater than 20% for the calendar year.
With that century-long context in mind, we can focus more recently on the last 10 years of Dow Jones Industrial performance, as shown in the table below.
The variation in annual returns from the Dow Jones Industrial Average is not only unsettling against the 100-year backdrop of 7.1%, but offers little insight as to where the next year may lie in the performance spectrum. For that, you can find a great deal more perspective in a visual interpretation.
While the overall direction of the market has a mean, slope and standard deviation that can be statistically calculated, I find that the chart tells the story even better, as it provides a very quick visual assessment of whether the market is priced at the low or high end of its range.
Drawing long-term trend channels is very helpful for this exercise. Even more valuable insight is gained from spotting when trends change-not just when they go from up to down, but when they remain in their current direction while making a significant adjustment to their slope.
The reason I bring this up is because I believe an important change of slope is currently occurring in the broad market. The chart below illustrates.
As the stock market climbed out of one of the most dramatic corrections in its history during the financial crisis of 2007-2008, one would expect that the initial recovery stage would be somewhat steep, and as the market approached a more "normal" valuation, that rate of advance would return to the expected long-term rate. (The statistical term for this phenomenon is "reversion to the mean.")
The chart shows that to be very much the case over the last two years.
The rate of growth projected by the blue lines actually comes very close to the long-term average over the last 100 years as mentioned above, and given that current rate of advance, the market appears to be sitting high in its range.
In an environment characterized by historically low interest rates and GDP forecasts for 2013 of only around 2.5-3.0%, even the growth rate of 7% may be somewhat optimistic.
Sometimes it just helps to view things from a different angle.