Recently, we got some press (here, and here) alluding to our unsophistication (in a respectful way) for using a price only chart since the 1970s and inferring that stocks were attractive using a simply exponential trend line drawn on this chart. A wise investor should know to use more data. Fair enough.
Is more data better? Generally yes, but not always. In this case, if you only have price data, then using 100 years of data is a mistake. If you want to look at the last 100 years of stock market data for the purpose of drawing exponential trend lines, it is imperative that you do so with a total return index, not a price only index. The abridged version of stock market history is that stocks were largely purchased during the first half of the 20th Century for their potential to pay dividends and during the last half for their potential of capital appreciation. The only way to make an apples to apples comparison between these two distinct periods in stock market history is by using total returns. If you don't have 100+ years of total return stock market data handy and need a quick chart to approximate this trend, you could us a price only chart over the last 30 to 40 years.
So, how does the stock market look relative to its exponential total return trend when looking at data since 1871? Undervalued. Just take a look at the chart below.
Chart courtesy of dshort.com. Click to view larger image.
Ultimately, you can make a chart say just about whatever you want it to say, so no one's investment strategy should rely on a single chart with a trend line. Ours never has. Even when investors don't agree, those who do investment strategy very well build a case with several pieces of evidence. We try to do that with a basket of sentiment, monetary, and valuation indicators. We can't know what we don't know, but the story that our broad basket of indicators gives is the same message that the simple 40 year price chart (for my fellow rednecks) and the 140 year total return chart (for you Ivy Leaguers) give, which is - be bullish.
Mark Dodson, CFA
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