Reversion to the mean is so truthy

Aaron Pressman

The oldest adage in investing must be what goes up must come down. It’s appealing in a simplistic, gut-check sort of way but it’s totally wrong. Everything from the economy to the stock market to the price of movie admissions has gone up, up, up for a long, long time despite occassional hiccups. A slightly more refined and truthier (to quote Stephen Colbert) version of the saying is that markets tend to revert to the mean. Usually it’s cited to argue that a market will return to its average performance or valuation level, i.e. that a strong performing market will weaken.

For example, everyone knows that small caps have outperformed large caps for six years running, so reversion to the mean says the streak must end. As I noted back in March, of course, it depends what mean you’re measuring. By some measures, small caps still have a way to go to catch up to the outperformance of large caps in the 1990s. Back in early 2003, you heard it about gold funds.

Now we’re hearing the same tired refrain about international markets. They’ve walloped the U.S. four years in a row (S&P 500 versus MSCI Eafe or MSCI World ex-US indicies), so must be time to overweight the U.S. Again, it all depends on how you slice it. By key measures, the U.S. market still has some time to spend in the relative performance penalty box.

Consider the forward price-earnings ratio of the U.S. versus the rest of the world (that’s the ratio of stock prices to projected earnings for the next 12 months). From the mid-80s through the mid-90s, the U.S. forward p-e was lower, often much lower, than the ratio for the rest of the world, Jim Paulsen, chief investment officer at Wells Capital Management, notes in his monthly research report. Then the U.S. p-e catapulted ahead reaching a peak of almost 140% of the world’s p-e in 2000. That also coincided with a period of the dollar strengthening dramatically.

Since then, the ratio has remained stubbornly above 110% of the rest of the world’s p-e, even as the rest of the world grows faster. Given that Paulsen also expects further weakness in the dollar, another boost for U.S. investors in overseas markets, the trend has hardly reached its end point. "International investors should continue to enjoy augmented returns," he writes. There may well be some mean reversion, but which mean the markets revert to is the most important question.

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