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.

(Click on image to enlarge)

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).

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Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more consistent defensive alternative to ...

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