Why Investors Need To Pay Attention To Mean Reversion

Markets have a habit of rewarding excess enthusiasm before abruptly pulling investors back to reality. In this analysis, we explore the concept of mean reversion, why soaring stock prices can become disconnected from fundamentals, and whether today’s AI-fuelled rally is creating the conditions for future disappointment.

Will stocks revert to their long-term means?

If there is a single market concept we should always remember, it is called the ‘reversion to the mean’.

In a nutshell, this means that when prices move pulled far away from its long-term trend, they will, eventually, return to this trend. 

Say, for example, over a three-year period a company ABC earns annually $21, $24, $28 while its stock price rockets $30, $86, $260. In other words, XYZ’s market value is pulling far ahead of its earnings. This is unsustainable forever. The mean reversion concept suggests that prices will, sooner or later, return near its earnings. 

Why is this behaviour important in markets? Because we see this ‘pull away, return to mean’ at work all the time, in various assets classes.

Look at weekly chart of QQQ, the ETF on the red-hot Nasdaq 100 Index.

While QQQ trended upwards most of the time, after a few quarters they return to the 200-day moving average (proxied by the red-line). Since April, this tech index has surged far away above its long-term trend. The angle of attack has seemingly steepened immeasurably.

Historically, whenever prices race ahead like this, financial gravity ensured that the index returned to its mean.

 

By this principle a few investment firms are downgrading the potential long-term returns of large-cap US stocks.

For example, GMO, a fund manager with $70 billion under management, recently published its 7-year Asset Class Forecasts. Here are three interesting estimations from the chart:

• US large-cap stocks have the largest negative real returns over the next 7 years. Why? Because prices have rallied significantly ahead of the companies’ earnings. The sector is almost ‘priced to perfection‘.
• US Small-cap stocks are expected to fare poorly, too.
• Emerging equities are envisaged to deliver negative real returns, but not as much as US stocks

Interestingly, large- and small-cap US equities set to underperform cash (last column on right). It is not hard to see why. US 2-year bond yield is above 4 percent, which is not a bad return of idle capital.

Berkshire Hathaway (BRK.A) is famously cash rich – and now sits on a massive $397 billion of cash. Its annual interest income alone exceeds the EBITAs many listed companies.

Source: GMO/Advisor Perspectives

US stocks large and small pump!

The only reason I’m highlighting this reversion concept is because ‘easy money’ is now being created on a massive scale in the US and some other stock markets.

SpaceX (SPCX), the Elon Musk-led space exploration firm that went public last week, jumped 50% in three trading sessions, valuing the loss-making company at more than $2 trillion. Overnight, the company created many billionaires and millionaires, which some estimated the latter at 4,400.

Furthermore, many companies have recently joined the “1T club” – companies that are worth more than US$1 trillion in public valuation. According to companiesmarketcap.com, there are now 16 companies in this elite club.

Over the next few weeks, OpenAI and Anthropic will probably join burgeoning group.

What is even more interesting is that the current US equity bull run is no longer limited to mega tech companies.

The so-called ‘Forgotten 493’ – stocks that are outside the ‘Magnificent Seven’ – have also rallied hard.  Look at the ETF behind this idea, Defiance Large Cap ex-Mag 7 (ticker: XMAG), below. Prices advanced by more than 18% from its March lows to new all-time highs.

And the Russell 2000 ETF (IWM), a fund capturing the smaller side of the US listing market, is also propelling to fresh highs this summer. Many small caps have jumped to 52-week highs.

That’s why GMO anticipates that US Small-cap sector will also fare poorly in the next seven years as prices are running away from their fundamental anchor.

Emerging markets are riding high on booming AI

The third asset class to show a negative forecast in GMO’s chart is the emerging market.

This is interesting because the MSCI Emerging Market chart is still charting a firm uptrend. The MSCI EM ETF (ticker: EEM), for instance, is amidst a multi-year rally following the breakout at 55 earlier (see below).

Three major stocks pulling this index higher: Taiwan Semi (2330, market cap=$2.2 trillion), Samsung Elec (005930, $1.5 trillion) and SK Hynix (000660, $1.12 trillion).

Why, you wonder, are these trillion-dollar stocks in an “emerging market” basket? Good question. But that’s not the main concern. The issue here is that these stocks are driven by the booming AI. Given the size, business exposure and valuation of these three stocks, they are no longer different to the US mega tech stocks. Their vulnerability to mean-reversion is no less.

But the EM asset class as a whole is not as over-stretched as US equities (yet), there may be space for the boom to filter out to other EM stocks outside this Big 3.

One last chart: CAPE

Are we, then, in a bubble and due for to a reversionary correction? Perhaps, but this depends on your investment time horizon. A long-term investor will probably wait for the bullishness to cool off before picking up risk.

Lastly, I end this week’s Macro with this important chart – Shiller’s latest CAPE.

Crudely, this CAPE measures the valuation of US stocks. The higher CAPE, the most expensive the valuation. This ratio visibly mean reverts over time. During the DotCom mania back in 1999, the ratio soared to a record 44.2.

At 41.4 (June), the ratio is now sitting at its second highest valuation ever in 150+ years.  Will the ratio surpass DotCom’s highs?

If it does, remember these words of credit investor Howard Marks: “There Is No Asset That Is So Good That It Can’t Become Overpriced and Lethal.”

Source: wikipedia