The Seven Percent Solution

Before anyone reads this blog, I should warn them that I am literally a greybeard. You can assume that these are the meanderings of an addlepated geezer or reflections of someone who had spent several decades as a hedge fund manager, still retains most of his brain cells, and wishes to share his experiences and observations about the current state of financial assets. If you accept the latter, read on.
The long term growth trend of the S&P 500 Index's price is around seven percent annually. It is no coincidence that the long term growth of the Index's earnings is roughly seven percent as well. That growth rate results from the aggregate effects of labor force growth, productivity gains, and price increases.
Stocks and indices trade in channels, with an upper trend line and a lower one. I am especially interested in the lower one because it can give one a rough idea of very long term downside risk. There are seveal ways to compute where the S&P 500 would be on the lower line of the channel:
(1)Take the bear market bottoms of 1974, 1982, 1987, 1990, and 2003 and form a trendline; or take each of those lows and compound at seven percent. Seven percent doubles roughly every ten years, so this makes the computation quite easy. For example, in 1987, the Index bottomed around 205. Twenty years later, compounding at 7% a year, the Index would have quadrupled to 820. Or take the 1990 low of around 290. Compounded at 7% a year, the lower trendline would be around 914. Or the low of 775 in 2003 at becomes 1015 today. Apparently, the lower trendline is at least more than 25% below the Index's price today of around 1400.
Why doesn't Wall Street ever talk about this? The market rarely touches this downtrend line. After all, since 1974 there have been only five times the Index came close to the lower trendline. That's once every six years! Not a parameter useful in an industry that thrives on day to day activity preferably in an up market.
Implicit in this exercise is a strong belief in the concept of "reversion to the norm or mean".
For example, in aggregate, the profit margin of the Index is currently around 13%, much higher than the average 8%. The average yield to maturity of the ten year U.S. Treasury note is roughly 300 basis points above inflation. Now it is 210. If you took the $92 earnings estimate of the Index for 2007 and reduced it to reflect an 8% margin, the estimate would be $57. If you upped the inflation premium to 300 basis points, the ten year would be around a 5.4% yield to maturity. If you then took $57 of earnings and 5.4% yield and inserted them into a dividend discount model, you would probably come out with a number far below 1400 in the Index, perhaps close to the figures we arrived at using our "seven percent solution".
My conclusion is that in order to have a belief that the Index is cheap currently, you must not be a believer in the notion of reversion to the mean.
On my next blog, I shall try to explain how I used to find entry points to go long in a bear market .