The S&P 500 is down less than 10 per cent from its peak in early January following this recent rally.
But when the broad stock index benchmark is observed and compared to other periods in time over decades, it is still clearly overvalued – by a lot.
Does that mean there is more damage to come?
Not necessarily. But maybe.
Have a look at these intriguing charts and accompanying commentary from Current Market Valuation, and make up your own mind.
Mean Reversion is the fairly unsophisticated concept that “what goes up must come down”.
It is generally true that while the day-to-day movements of the stock market are chaotic and unpredictable, long term stock market returns tend to adhere to somewhat predictable upward trends.
Deviations from the trend can last years, or even decades, so this is not a helpful short term trading strategy – rather, a useful indicator of overall market valuation relative to modern history.
We use S&P500 daily close data, available from Yahoo Finance back to 1950.
This data is not inflation adjusted, so we index it to current dollars using CPI data from the US Bureau of Labor Statistics.
The above S&P chart should be no surprise to anyone, and clearly shows the last ~70 years of upward progress.
The exponential regression shows the approximate 10% annual returns that investors have become accustomed to receiving in the modern era.
Clear outliers on the chart are the bear market all through the 1970’s and early ’80’s, the internet bubble of the late 90’s (and subsequent collapse), as well as the great recession of 2008.
From the beginning of recovery in 2009 through the early 2020 we’ve enjoyed a bull market in length and scale greater than any other in modern times.
We can see that the S&P500 is currently priced above the trend line, but it isn’t obvious how far away we are from the trend relative to prior peaks.
To see this more clearly we re-map the data relative to the trend, seen below, including horizontal bands indicating 1 standard deviation.
Here again is the same data, showing a zoomed-in view of only 2000 to present:
The de-trended data shows that the S&P500 is 62% above its historical mean, even accounting for expected growth.
This places the indicator as being currently Overvalued.
History suggests that over time the market ought to correct and revert downwards.