Mean Reversion suggests that the US stock market is Overvalued

 SOURCE:

S&P500 Mean Reversion Model (currentmarketvaluation.com)

Overview

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We find that the S&P500 is currently trading 40% above its modern-era historical mean, (about 1.1 standard deviations) indicating that the market is Overvalued.

Theory & Data

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Mean Reversion

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.

S&P500

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. One could just as easily use other broad market indices (Russell 2000, Wilshire 5000) and get very similar results. We use the S&P simply because we've already used the Wilshire 5000 in our Buffett Indicator analysis, and since this is such a high-level indicator we're comfortable using the S&P as a more narrow proxy of overall market valuation. The S&P also tends to be the measure more people are familiar with, so this indicator may be more relatable. The data is shown below, along with an exponential regression line showing the trend.

Figure 1

Current Values & Analysis

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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.

Detrending

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.

Figure 2

Here again is the same data, showing a zoomed-in view of only 2000 to present:

Figure 3

Results

The detrended data shows that the S&P500 is 40% 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. See our ratings guide for more information.