Mean Reversion and Other Mathematical Fairy Tales

At true market peaks, investors typically don’t have fear of heights—rather like this steely nerved climber, circa 1925. Photo by Hulton Archive/Getty Images.

Fear of heights. Some folks feel it staring out the window of a tall building. Others feel it at the top of a mountain. These days, it seems a lot of investors feel it after five-plus years of bull market and a 156.2% rise in the MSCI World Index.ⁱ Some say stocks are too darned pricey. Others say the bull is just too old, and folks should walk away winners. And some say we’ve gone too long without a major pullback. All are off base, in our view—and all, counter-intuitively, are evidence this bull has a ways to go.

We often say bubble fears are self-deflating—this isn’t merely a quip. Markets are pretty darned efficient. They reflect all widely known information, beliefs, forecasts and—yes—fears. When fear of heights is splashed across headlines the way it is today, it’s a safe bet many investors feel the same—headlines both influence and reflect broad sentiment. That sentiment in turn influences folks’ trading decisions, which helps keep prices in check. Widespread fear of heights is a brake on the runaway prices folks fear. For investors with the grit and determination to stay in stocks, this is bullish.

That said, it isn’t mere contrarianism that has us greeting these bubblicious headlines with a hearty “full steam ahead!” There are fundamental reasons why we’d suggest investors not pay any of today’s “it’s too high!” arguments much heed.

Take, for example, jitters over a high and rising cyclically adjusted price-to-earnings ratio (CAPE), which compares the market’s price to the past 10 years of earnings, adjusted for inflation. We aren’t bashful about pointing out the flaws with CAPE’s methodology, and we won’t beat a dead horse here—suffice it to say the past 10 years tell you nothing about the next one, three, five or 10 years, because the past doesn’t write the future. What does it matter that CAPE today, at 25.6, is 54% above the 133-year average? CAPE was only 20.36 in September 2008. Was that a good time to be in stocks? What about the last bull? Then, CAPE hit its cyclical high in January 2004, at 27.65—the bull lasted another 44 months. In the 1990s, CAPE hit today’s level for the first time in September 1996. Stocks peaked three and a half years later.

Still think CAPE is predictive? Well, have we got a deal for you! The CAPE for Russia’s RTS index is only 6.5! A bargain! Of course, Russia probably also looked tantalizingly cheap in January 2013, when its CAPE was 7.5. RTS is down -30.2% since then.ⁱⁱ

Normal P/E ratios don’t fare better. Some say the S&P 500’s current 12-month trailing P/E is too high at 16.5—above the long-term average! Run! But by that logic, investors should have hit the exits in March 2009, when the S&P 500’s 12-month trailing P/E was 110.37. Does anyone really think stocks were historically, prohibitively expensive at the bear market’s bottom?

Valuations aren’t the only reason folks are getting dizzy. Some are slicing and dicing the bull’s age and magnitude for signs of how much longer it can last. Some point to the fact the S&P 500’s 175.9% price return since the March 9 low is just under the bull market average of 180% since 1921 and well above the 115% median return (numbers we’d quibble with, considering reliable data go back only to 1926). But tell that to the 1990s bull, which gained 417%, or the 1982-1987 bull, which notched 229%. Averages aren’t predictive—they are a result of highly variable returns, but they don’t tell you what those variable returns should or shouldn’t be. Actual returns aren’t average.

We’d apply the same logic to today’s other big age-based argument, which says when bulls turn five, they average another 26% before rolling over. We count three bull markets lasting that long since 1926: 1949-1956, 1974-1980 and 1990-2000. After hitting the five-year mark, they continued another 73.8%, 28.2% and 163.6%, respectively.ⁱⁱⁱ Variable! And not at all predictive for today.

Where stocks go from here depends on what fundamentals look like moving forward—not past performance. Every fund prospectus and investment report says past performance doesn’t dictate future returns for a reason: It’s true! Those who rely on valuations and patterns to predict the future make one of the most fundamental, destructive behavioral errors in the book.

So how will you know when stocks are too high? Chances are, headlines won’t tell you. If it’s anything like the last time markets were euphoric, most financial media will be chock full of reasons why valuations aren’t too high, why the bull can run on forever and a day, why there are no risks in the world, and why you should go all in on some spanking new technology. Those who dare say otherwise—who provide a rational look at deteriorating fundamentals—will be laughed at.

For now, we’re nowhere close. The economic and political backdrop remains exceedingly favorable, and with fear of heights everywhere you look, it’s safe to say the majority of investors still doesn’t notice.