Does A Record High Dow Mean My Population Model Of Investment Pricing Is Wrong?

If you’ve been following this blog since the beginning, you may know that I take a fairly dim view of investment.  If you haven’t read the linked article, you’ll want to do so before continuing or the rest of this won’t make much sense.

Today’s market news is that the Dow Jones Industrial Average (DJIA) made new record all time highs, eclipsing the previous highs from 2007.  This is, as news goes, only sort of important   The DJIA long ago ceased being particularly relevant when compared to the S&P 500.  The concept of Dow industrials and comparing them to DOW transportation stock to generate market signals (that’s “Dow theory” for the uninformed) has more or less been laid to rest by modern confusion about what constitutes an “industrial” stock.  For example Microsoft is part of the DJIA, but most of their products are licensed bits, not physical things delivered via a truck or rail car.  As a result their delivery won’t trigger business for transportation firms, and the whole point of Dow theory really doesn’t apply.  Given that, the DJIA is now pretty much a joke.  It’s just 30 big US stocks.  None the less, the DJIA lurches on like an unwanted extra in a zombie movie.  And of late, it’s been lurching up.

Contrast the DJIA’s behavior to my theory linked above about investing in the US.  The theory is basically that the supply of investments is proportional to working population  and the demand for investments is proportion to late-career working population.  In other words, the older the work force the more expensive/overpriced investments will be.  My logic was that as the baby boomer demographic (by far the largest in the US) hit retirement in 2000 and on average started to divest assets, asset prices would peak and start to fall in real dollar terms.  So a new high in the DJIA raises the question: am I flat out wrong?

The first thing to note is that it’s totally possible I’m wrong.  It happens all the time.  If you’re looking for an investment guru who’s always right, you’ll have to find someone else less honest than me.  After all no one’s always right, but it’s easy to pretend you are on the internet.  But in this case I don’t think I’m wrong, or at least I’m not wrong YET.  The first thing to note is that the DJIA is not inflation adjusted.  And while inflation has been low (slightly less than 3% per year), all those little multipliers add up.  DJIA 14200 today means something different than 14200 in 2007 – specifically about 18% less something.  In inflation adjusted terms, 2007 itself wasn’t a peak.  That came in 2000.  This chart lays out the sequence of events.

I’m not an inflation alarmist.  A little inflation is good for the economy.  It gets people off their asses and money out from under mattresses.  But inflation does have to be taken into account when comparing the prices of things at different times.  And once it is, you’ll see that the S&P is about 23% off the all time inflation adjusted high in 2000.  If my model is correct, we won’t see those prices again in this demographic cycle.  So I’m not wrong yet, but I’m within 23% of being wrong.  It’s always nice to have a definite point which, if hit, you know you’re wrong.

From a medium term (weeks) perspective, I’m long the S&P in the speculative alternatives portfolio.  That’s a result of the trend following mechanism built into the portfolio.  So as a practical matter, I don’t mind if it turns out I’m wrong and the S&P makes new inflation-adjusted highs.  I’ll be very slightly richer if I am.  Now, you may wonder why I’ve made a bet where I’ll profit if I’m wrong.  The reason is internal consistency in the way the speculative alternatives portfolio works.  It’s been long the broad market since about S&P 900.  Whatever happens now is just the tail end of what has already been an enormously profitable trade.

If we do make new inflation-adjusted highs, it will mean is that I need to adjust my long term (decades) philosophy to be less pessimistic.  I’ll keep you posted and we’ll see what happens.  It’ll probably take a year or three to play out, but I’m not planning on going anywhere.


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3 thoughts on “Does A Record High Dow Mean My Population Model Of Investment Pricing Is Wrong?

  1. Hey W,

    I’ve been hanging around SeekingAlpha. I’m not sure this is a good thing, but they do love to backtest their ideas and present them in unique formats. Then gush over their 15+% CAGR returns over various rolling 3 year periods. Or ten year 20% annualized returns … that lost 50% in 2008. Cherry picked, pair-switching, ETF momentum strategies seem to be all the rage.

    I”m not sure what to think of it all.

    I’m trying not to buy into the hype, but as I just opened up a trading account with a paltry $50K, I’m wondering how your speculative alternative to investing is doing. I tried to backtest it, but had some difficulties with fluctuating beta. An update would be fantastic. I suspect conditions, currently, aren’t the greatest, but given that I don’t have a clue where the market is going (part of me still thinks I should be investing in gold and silver) I suspect the market has more than a few surprises in store for us.

    It would be nice to adopt a strategy that has the potential to protect us from a few of those.

    All the best,

    • I’ll try to get an update up that catches the last 3-4 months. One thing I can tell you is that the speculative alternatives portfolio did not in general fail through the 2008 crisis. The S&P trend follow did very well (short at 14,000ish and back long at 900ish) and most of the beta neutral pairs did OK. Some did great.

      You should be able to calculate your own beta in most backtesting platforms. It’s simply the slope of the linear regression.

  2. Cheers on the beta. I wasn’t aware that it was that simple. Thanks!

    Insofar as okay and great are concerned for the beta neutral pairs, that amounts to a sheer win unless other evidence presents itself. And you’re right, your trend following did quite well during that crash.

    It seems there’s considerable confidence building. but who is it that said the danger starts when chaos begins to look orderly? So I’m looking at all the possible worst case scenarios for any model I may adopt. I figure that’s probably as good a place as anywhere to begin.

    Thanks for the response, I look forward to your updates and future posts.

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