Investment lesson (and chart) of the month:
This month, let's talk about mean reversion, and how it could impact market returns. We often talk about how, in our Affluence Investment Fund portfolio, we seek to own more of the assets and sectors that are cheap (relative to history) and less of those which are expensive. This strategy relies on so-called "mean reversion", meaning values will return to at least their long term average over time. It also requires patience. Over the past three to four years, the differences in price between what is cheap and what is expensive have continued to widen. That's both frustrating and exciting for us.
It's frustrating, because the divergences in many of these asset classes are very close to historic extremes. It means we've been swimming against the tide for quite some time, and the tide has been getting stronger. It's exciting, because we've managed to outperform our investment benchmarks even though we've been in what, for us, has been a difficult environment. Its also exciting because when that tide turns, there's potentially a lot of easy ground to make up.
Right now in our Affluence Investment Fund, we're overweight Australian stocks, small caps, LICs, shopping centre REITs, commodities and other value plays. We're underweight developed market stocks (particularly the US), technology and growth stocks. To give you some idea of the level of mispricing in markets, Canadian analyst Dave Rosenberg has taken a look at what would happen if some of the overvalued/undervalued asset classes returned to normal, using a minimum of 20 years historical data. Here's what he had to say:
"We have seen the value trade try to turn around in fits and starts over recent years, but can never get going on a sustained basis. We’re not going to try and predict when the ultimate turning point will happen, but at such extreme readings in its relationship to growth stocks it is a matter of when, not if. Remember that history is replete with examples of assets ultimately mean reverting in ratio-terms, not levels. No extreme condition has ever lasted indefinitely. Now in each one of these cases, since these are ratios or relative pricing, one can go down, one can go up, or they can magically mean revert right in the middle.
If we had a situation where the asset class in question had to mean revert all on its own, this is what the price decline would imply:
- Growth stocks relative to value -43%%; or value +70% relative to growth.
- S&P 500 relative to commodity index -60%; or +150% for the commodity index relative to the S&P 500.
- Nasdaq (tech stocks) relative to S&P 500 -40%; or +50% for the S&P 500.
- All-country index (relative to ex-U.S. index) -27%; or +37% for the ex-U.S. index.
It’s not to say that momentum in the winners can’t continue, but nothing goes up in a straight line forever. Eventually, investors begin to get lost in the excitement of the moment and perspective is lost. As the relative strength of these asset classes reaches extremes investors should begin to be wary.”
We might be there right now. This year so far, to the end of August, there hasn't been such a wide chasm between the best and worst sectors in nearly 90 years, as you can see in the chart below.