When Mean Reversion Fails

Are equities overvalued?

Is the economic expansion long in the tooth?

In attempting to answer these questions, we often look to averages:

-What is the average valuation?

-What is the average length of an expansion?

We then take the present environment and compare that to the average past to make definitive statements about the future:

-Equities are overvalued and must go down.

-A recession is long overdue.

In making such statements, we’re saying that something deviating from an average must immediately move back to that average. In markets/economies, is that how it works? Let’s take a look…

Are Equities Overvalued?

It’s not hard to come to the conclusion that U.S. equities are “overvalued.” By almost any objective measure (P/E, P/S, P/B, P/CF, etc.) current valuations are above historical norms, and in many cases substantially so.

The popular CAPE Ratio (or “Shiller P/E,” which uses an average of 10 years of earnings data in the denominator) on the S&P 500 recently crossed above 30 for only the third time in history. Going back to 1871 when the data set begins, the average CAPE Ratio is 16.79. At its current value of 31.09, the CAPE is 85% above that average, meaning the S&P 500 would need to drop 46% tomorrow for valuations to move back to their historical average.

S&P500 CAPE ratio vs Historical Average since 1900 to 2017 graph1

Should we expect the S&P 500 to fall 46% tomorrow?

No, of course not. Just because something is above average doesn’t mean that the next stop is the average.

In the past 20 years, the S&P 500 has sported a CAPE Ratio above its historical average 97% of the time or 233 out of 240 months. Only in the brief period from November 2008 through May 2009 were stocks deemed “undervalued,” trading at valuations below their long-term average.

As it turns out, long periods above or below the historical average valuation are not as uncommon as one might think. A market that is undervalued can remain undervalued for a long time (243 months from 1907 to 1927 just as a market that is overvalued can remain overvalued for what seems like an eternity (239 months from 1988 to 2008).

CAPE Ratio Streaks since 1900 to 2017 chart2

These long stretches of over/under-valuation cause the “average valuation” to fluctuate over time. The average CAPE Ratio is now more than 2 points higher than it was in the mid-1980s, as the S&P 500 has spent near all of that time above its long-term average valuation.

Historical Average CAPE Ratio since 1900 to 2017 graph3

So not only can a market remain overvalued or undervalued for decades, but the baseline definition of over/under valuation can change as well.

What about those that say the stock market has been “overvalued” since June 2009?

Technically, they are right, as the CAPE Ratio first moved back above its long-term average back then. But there’s a big difference between being right and making money in markets. Since June 2009, the S&P 500 has gained over 226% in total return. Those betting on a reversion to mean are still waiting for it to occur, as overvalued has become more and more overvalued.

The historical record shows that betting on mean reversion when it comes to valuation is a fool’s errand. There is nothing that says an overvalued market cannot go higher. In fact, more often than not, it does just that.

S&P 500 Average forward returns since 1928 to 2016 chart4

Is the economic expansion long in the tooth?

It would be hard to say that it’s not. At 99 months and counting, the current expansion is already five years longer than the average expansion dating back to 1854.

NBER Expansions and Contractions 1854 to 2009 chart5

The average length of an expansion has increased significantly over time. From 1854-1919, the average expansion lasted a little over 2 years. This increased to almost 3 years from 1919-1945.

By comparison, recent decades have seen a golden age for uninterrupted growth. The last four U.S. expansions have averaged 8 years in duration.

US Expansions since from 1982 chart6

As a result, the likelihood of seeing a recession at any point in time has fallen dramatically.

US Recession odds chart7

Back in late 2012, when the U.S. expansion passed its average duration (39 months), there were a number of recession calls from prominent analysts.

Is US already in a recession

Five years later many are still predicting a recession, using the logic that we are “overdue.” These analysts remain correct in saying that the expansion is longer than average, but profiting from such an observation (by shorting the stock market) has proven to be a difficult task.

Similar to overvaluation, this is not inconsistent with the historical record. An economic expansion that is longer than average is not a reason (by itself) to expect a decline in stocks. More often than not, stocks continue higher.

When Mean Reversion Fails

None of this is meant to suggest that trees grow to the sky. Mean reversion has failed to occur but that doesn’t mean it has been eradicated. Valuations will eventually move lower and the economic expansion will eventually come to an end.

But predicting exactly when that will occur is the key, and simply comparing the present environment to an average of the past is not going to help you with such timing.

Are stocks overvalued (with a CAPE of 31) in an expansion (8 years) that’s long in the tooth? Sure, but consider this before thinking it must end here…

In Japan, the CAPE Ratio peaked above 94 back in 1989.

Japan CAPE ration since 1979 to 1989 graph8

Source: Michael Batnick, Ritholtz Wealth

In Australia, the economy has expanded over 25 years without a recession.

Australia goes 25 years without recession image9



Related Posts:

Is This 1929 or 1997?

Recession Odds and Soothsayers

The Difference Between a Prediction and a Probability

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. Charlie holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and also holds the Certified Public Accountant (CPA) certificate.

In 2017, Charlie was named the StockTwits Person of the Year. He is a frequent contributor to Yahoo Finance and has been interviewed on CNBC, Bloomberg, and Fox Business.

You can follow Charlie on twitter here.


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