“Reversion to the mean-RTM, the pervasive law of gravity that prevails in the financial markets-never stops. While its drumbeat is hardly regular, it never fails. For the returns of market sectors, of managed investment portfolios, and even of the market itself mysteriously return, over time, to norms of one kind or another.” – John Bogle founder of Vanguard
What is ‘Mean Reversion’?
To understand ‘mean reversion’ and how it applies to investing in the stock market, it is helpful to first define the term. A ‘reversion’ is defined as the return of any condition back to a previous state. In the case of a ‘mean reversion’, the thought is that any price that strays far from the long-term norm (statistical mean / average) will at some point revert back to its long-term norm.
How does it apply to investing in the stock market?
We then apply this to investing in the stock market. The stock-market itself has a mean / norm valuation, typically measured through metrics such as Price/Earnings Ratios, which attempt to measure the fundamental (true) value of the stock market.
John Campbell (Professor of Economics at Harvard University) and Robert Shiller (Nobel Laureate and Professor of Economics at Yale University) discuss this concept in a research paper[1] written in April 2001 regarding the stock market at that time, which had risen to levels far above its fundamental valuation due to the tech bubble:
“When stock market valuation ratios are at extreme levels by historical standards, as dividend–price and price–earnings ratios have been for some years in the US, one naturally wonders what this means for the stock market outlook. It seems reasonable to suspect that prices are not likely ever to drift too far from their normal levels relative to indicators of fundamental value, such as dividends or earnings.
Thus it seems natural to give at least some weight to the simple mean-reversion theory that when stock prices are very high relative to these indicators, as they have been recently, then prices will eventually fall in the future to bring the ratios back to more normal historical levels. The idea that they should do so seems intuitive and basic. Metaphorically, when one is mountaineering, one can enjoy the exhilarating view from high up on a mountain, and may look forward to the possibility of discovering a way up to a much higher level. But one will reflect that, realistically, at a random date years from now, one will probably be back down at ground level.”
Inevitably the stock market ‘reverted to its mean’ valuation when it crashed from 2000 – 2002, and in-fact equity returns over that decade (from 2000 – 2010) were less than 1%/yr.
How important is it today?
This concept is very important to understand in today’s stock-market environment, as we are once-again reaching valuation levels that are well above the mean / norm.
In fact, the market valuation metric that Robert Shiller himself created (called the cyclically -adjusted price/earnings ratio or CAPE) is above 29 (see graph 1 below), a level only seen twice in history in the years 1929 and 2000. Both times the stock market saw historic crashes in the years to follow.
http://www.multpl.com/shiller-pe/
What should investors do?
"People should be cautious now," Robert Shiller said. "We have a high market. That doesn't mean I would avoid it altogether… I would say have some stocks in your portfolio. It could go up 50 percent from here. That's what it did around 2000, after it reached this level, it went up another 50 percent. So I'm not against investing in the stock market when you consider the alternatives. But I think if one wants to diversify, US is high in its CAPE ratio. You can go practically anywhere else in the world and it's lower," Shiller said. "We could even set a new another record high in CAPE, that's not a forecast."
We agree with Shiller’s suggestion here in-that diversifying the stock in your portfolio may be your number-one option, and that stocks outside of the US show better long-term promise. For example, the CAPE in Europe is closer to 18, Australia is ~17, and the emerging markets are less than 16, all very reasonable valuations.
We also agree that investors should not over-react and suddenly shift all their stocks to conservative investments such as bonds or cash. The reality is that we don’t know exactly when the next ‘mean reversion’ market crash will take place. With interest-rates still near all-time lows, there are few investments other than stocks available which will provide reasonable returns.
However, for investors nearing retirement (particularly those 5-years or fewer away), we recommend considering a reduction in risk of your portfolio. The amount of risk reduction will depend on factors such as your current risk level, the amount of income you will need to draw from the portfolio at retirement, and your risk tolerance.
How does this impact my long-term planning?
We now know that currently the US stock market has a high valuation; and due to the concept of ‘mean reversion’, at some point in the future we’ll likely see the market drop and revert back to its long-term mean / average.
So how does this impact your long-term financial plan?
For long-term planning purposes, we recommend assuming in your modeling that investment returns in US stocks may be significantly lower over the next 10-years than they were over the last 10-years.
Hopefully your whole portfolio is not comprised purely of US stocks, so this only impacts a piece of the overall portfolio. However, US Stocks often comprise a healthy chunk of any diversified portfolio so the impact could be significant.
Conclusion
The concept of ‘mean reversion’ is very important for investors to understand, as it is one of the most powerful and consistent market forces. While it does not tell us exactly how the market will perform in the short-run, it can provide us information on long-run future performance and therefore can be very useful for long-term financial planning.
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Copright 2017 Odyssey Wealth Design
CRN1882483-082817 Odyssey Wealth Design provides financial planning and wealth management to clients in Orange County, Irvine, Newport Beach, and around the country.
[1] Campbell, John Y. and Shiller, Robert J., Valuation Ratios and the Long-Run Stock Market Outlook: An Update (April 2001). NBER Working Paper No. w8221. Available at SSRN: https://ssrn.com/abstract=266191