The previous post introduced the Dow Jones Industrial Average (“DJIA”). While the chart in that post has an accurate representation of the index over time, it basically looks flat for almost a hundred years of its history, with most of the interesting stuff happening in the last 30 to 40 years.
Obviously, history is more interesting than a flat line. So, there is an alternative way to view the DJIA that can make some of that interesting history more apparent.
Essentially, the DJIA grows at a pace quickly enough over time that it can be approximated by an exponential curve. It’s not a perfect fit (if it was, then the market would be easy to predict!) but it is close enough that the index can be transformed with a natural logarithm.
Now, before you run away screaming at the thought of doing any math, just think of it as essentially removing the exponential property of the index to make a new time series that is more linear (aka straight). If that explanation didn’t help, then just trust me and look at the pretty picture below:
Ah, that makes history a little more interesting! But, uh, what are we supposed to make of this log thing?
Basically, it puts the past into a more comparable perspective. We know that the financial crisis a little over ten years ago was the worst market event since the Great Depression. But how bad was the Great Depression? Well, look at the little dip from 2007 to 2009. Now, look at the biggest dip on the chart and think about how much bigger it is than anything else. That’s the Great Depression. It was bad. We couldn’t see that on the chart that just showed the DJIA index in its usual form.
Since the log transformation of something exponential is supposed to be linear, I also added a linear trend line, which helps with benchmarking the market over time. If the time series is running above the dashed linear trend line, it can generally be said that it is a time of above average growth. If running below, then below average growth.
While the calculation of the dashed trend line is dependent on the time period selected and, therefore, is not a perfect science, it is still a useful tool if one wants to consider it as a general guidepost for potential mean reversion. That is, the potential for the main time series to trend back towards the dashed line.
Consider before the Great Depression, there was a big runup of the market beyond its trend and then the market came crashing down. Same thing before the financial crisis (although for a much longer time period). As of present, we are also running above trend.
This kind of analysis would basically get you laughed out of the company of most serious academics in the world of finance and economics. It’s very simple! And, there are plenty of time periods where the market ran below or above trend for a very long time. It’s definitely not a tool for prediction.
But, I also like these little simple analyses. To me, it’s kind of like a finger in the air to check wind direction. That isn’t an exact science either but it’s not useless. It conveys something that may or may not be correct or perfect but could imply the opportunity for further analysis. A finger in the air could be right or wrong but I will for sure defer to the Doppler radar.
The main takeaway here is that the Great Depression was really bad and this alternative view makes its severity a lot more noticeable. As far as the above trendline behavior though, the question then becomes, if we see something here then what do the more advanced methodologies say? That falls under an important topic of research generally referred to as market valuation and a good question to ponder for another day. For now, just look at how bad the Great Depression looks…jeez. In the next post, we will show another way to put that drop into a comparative context.
Related content:
The Dow Jones Industrial Average
What’s Next for Endless Metrics
Quarterly Changes in US Real GDP