Stock charts are distorted by compounding and inflation.
Inflation-adjusted returns are driven by technological waves.
Understanding waves and cycles will help to optimize your portfolio.
When analyzing the stock market, we often look back on history through a standard linear chart. This chart is familiar to most investors(figure1). It tells us over time the market goes up steadily. If you just buy stocks and hold them, you will make money in the long-run. You should be able to earn a positive return, if you have 10 years to invest.
Fig 1: The Steady Climb of the Dow Jones Industrial Average visualized on a linear chart.
(Note: I used the Dow because it is easier to get old data. For convenience I'll use the S&P going forward.)
The problem with the figure 1 is we are graphing a compounding function on a linear chart. Much of what looks like extreme gains is just compounding. These charts exaggerate the present and distort the past.
Long ago crashes look like blimps. The Great Crash is barely viable now, but it was very viable in the 1930s. The way to smooth for this is to use a logarithmic chart which graphs the results by percentage change. On a logarithmic chart the line slope is correspondent to the annualized return. This makes the Great Crash look like a big crash.
Fig 2: The S&P 500 graphed logarithmically. Past events are not distorted.
(Courtesy of Mulitpl.com)
The problem with the logarithmic chart is it reflects another compounding function - inflation. A chart of inflation looks like figure 3. This is the GDP price defoliator, it is the inverse of inflation.
Ten dollars in 1929 is equal to 110 dollars today. If I showed you this as an investment the chart doesn't look bad. This chart is embedded in the above charts(figures 1 and 2). Part of the upward slope is not real gain, it is just inflation. Economist call this the money illusion.
Fig 3: The steady climb of inflation
(Courtesy of the St. Louis Federal Reserve)
Real Gains Are What Matters
If we remove the inflation we get a different looking chart. Figure 4 is a chart of the inflation-adjusted S&P 500. Compare figure 4 to figure 2, both chart the stock market, but look completely different. The line slope between 1950 and 1990 is trending up in figure 2 but flat in figure 4. That's the inflation distortion.
If you look at figure 1 the stock market looks like a sure bet. In figure 4 it doesn't. It looks more speculative. The investment business would rather sell investors a sure thing, so they will more likely show potential investors, figure 1 instead of figure 4.
Investors are better served basing their investment decisions on figure 4 than figure 1.
Fig 4: The S&P 500 adjusted for inflation
A Stair Step of Gains.
At first glance figure 4 looks like a steady climb from 100 to 2,372. But, if we look closer at this chart we can see there are three distinct flat periods .
These are extended periods when the inflation-adjusted market is more or less flat for long periods of time. Investor's collect dividends, but there is no significant inflation-adjusted capital gains.
The market was at the same level in 1982 that it was 82 years prior in 1900, the 1933 was the same as 1871, 62 years prior. The 1992 level and the 1972 level, 20 years, 2016 and 2000 - 16 years, and 2006 and 1996, - 10 years. There is a pattern of long flat markets.
Fig 5: The inflation-adjusted S&P 500 shows extended periods of flat gains
The market stays in these long-term trading channels for decades. Investors don't make strong inflation-adjusted gains in stocks unless they are able to buy and hold between two of the channels, for example from 1950 to 1968 or 1982 to 2000.
Without holding through a channel shift, the investor mostly collects dividends with an inflation adjustment. Today the combination of dividend yield, approximately 2 percent, and inflation, around 2.4 percent, would yield investors 4.4 percent per year. This is a long way from the ten percent annual return often claimed.
If we look closer at the channels in figure 6, we can see a pattern of shifts. The shirts correspond closely to three mass shifts or productivity waves in history.
Mass-Industrialization (1871-1954)- The age of mass-production between 1870 and 1955 when we perfected the production durable goods like automobiles, airplanes, ships, refrigerators and other consumer goods.
This was a time of rapid advancement in the efficiency of production, increasing the output per person with more efficient design and assembly.
Mass-Computerization (1955-1995) - During the age of mass-computerization, we moved from giant mainframe computers to small portable laptop computers. These machines increased the efficiency of human thought, allowing workers to think and calculate faster. This allowed additional increases in productivity.
Mass-Connectivity and Globalization (1995-present), driven by the internet, cell phones, video streaming, and a connected global economy. This increased efficiency, but creating a conduit to share the information created by mass-computerization, between workers and countries.
Fig 6: Three waves of innovation and three flat market channels
The market could decline fifty percent and still be in the channel.
Economic cycles and waves are not new. They were put forth by Kondratiev, Juglar, Kitchin, Kuznets, Dewey, and others. Economist Joseph Schumpeter promoted the idea that these cycles could be combined into waves of innovation.
The stock market waves diagrammed in figure six, correspond roughly with Schumpeter's waves. Schumpeter identified waves from 1900 - 1950 and 1950 - 1990 and 1990-2020.
Fig 7: Long-term Kondratiev Waves postulated by Schumpter
(Courtesy of The Economist)
Schumpter's analysis suggests that the waves are getting shorter, and that the current wave will end near 2020.
The Problems with Waves
The problem with using waves to form investment theses is the shifts are much easier to see after the fact. Like most things, they are difficult to see into the future.
The other problem is they are rough estimates and the start and end dates tend to be imprecise. The turning points can come a few years early or a few years late.
Is the current breakout the start of a new wave or just a temporary channel puncture, like 1929? If Schumpeter is right, is the wave ending a few years early or will it end a few years late in 2022? It's impossible to know.
Another complexity is predicting the direction of the shift. Will the stock market keep shifting upward like it has or are the shifts fractal.
Are these small waves that make up a bigger wave. Is the next move is a down move as part of a bigger wave? It could be three up, two down. We don't know.
Another issue is maybe we are just seeing patterns in random data, maybe this is just random movement that happens to look like a pattern. There's always room for imagination.
The last problem is, even if you know the trend, you can still pick the wrong winners. You can see the growth potential of cell phones and pick Blackberry, instead of Apple, or see the future of internet search and go for Lycos instead of Google. It's hard to pick the winners in emerging technology.
Problems aside, these shifts can be helpful to investors formulating portfolio strategy.
First, understand the distortions in the graphs. At first glance the market looks like it just goes up as in figure 1, but in real terms, the market can go long periods without making a significant gain over inflation(figure 5).
Second, don't buy into the simple story that you can buy and hold and make an inflation-adjusted gain. Adjusted for inflation the market is barely above its 2000 high. That's 17 years of flat returns. The truth is you would have been better buying a government bond.
Third, it's hard to pick the winners of these technology shifts. I have a desk-drawer museum with at least five generations of Blackberry's (BBRY). The stock looked great in 2008. But now it's down from 137 to 10, who knew? So, keep a diversified portfolio, or use an ETF or fund to get diversification.
If you think robotics is part of the next wave, use the ETF (NYSEARCA:ROBO)(NASDAQ:BOTZ), or if it's drones (IFLY) or the Internet of Things (NASDAQ:SNSR). Avoid individual issues and unless you're a gambler.
Remember, that these waves lift all boats, so if you predict an up wave, keep a market diversified portfolio allocation.
Last, aim for a return above inflation. At the current inflation rate, money has a half life of around 30 years (72/2.4). Don't be fooled by the money illusion.
And last always strive for a risk-balanced portfolio. The biggest risk is the risk of being wrong. Do your own homework before investing.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational and discussion purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. All investment and speculations have risk. I am not your investment advisor, please consult your financial and tax advisers before investing.