Reversion to the Mean for Equities

 |  Includes: DIA, QQQ, SPY
by: John Lounsbury

The following is quoted from yesterday’s 5-Minute Forecast (a daily newsletter published by Agora Financial).

From "Mortgage Rates, Scary Jobs Details, Investing in 2009, Russian Gas Dispute, and More!":

By one metric, the future shouldn’t be TOO terrible for U.S. equities. Check out this chart, sent over by Rob Parenteau of The Richebacher Letter:

“The contraction of the total value of the equity market relative to GDP,” notes Rob, “has reversed nearly the entire premium introduced during the New Economy bubble years.

"If there is a reversion-to-the-mean process under way with respect to the equity market capitalization-to-GDP ratio, the most violent part of the move must be behind us. Given the severe recession developing before our eyes, however, we are in no rush to be buried beneath a landslide of earnings shortfalls, employment reductions and bankruptcy announcements.

"A fiscal push in early 2009 may help stabilize or improve the near-term earnings growth expectations held by professional equity investors, which are already much lower than those offered by brokerage house equity analysts. But the larger question remains: If financialization is not going to be the growth driver for the U.S. economy, what will take its place? If credit booms and busts are going to be restrained by a stripped-down financial system, especially one that is heavily regulated, what will drive earnings growth?"

Not noted by the the folks at Agora Financial, but obvious on the graph, is the overshoot of the mean in the two previous super cycles (1930’s - 40’s and 1970’s – 80's). If history is any guide, this cycle has still some way to go down to reach bottoms similar to 1941, 1974 and 1982. This graph is normalized to GDP. If we do not turn GDP around in the next 1-2 years (end the recession), the outlook for stocks is grim. It is my opinion that the recession will not become ingrained (if it does, it’s called depression) and will end within the 1-2 year limit, hopefully well within.

One other comment about overshoot relates to the often observed effect of overshoots to the downside tend to mirror the preceding overshoot to the up side. If that were to obtain to the current cycle, the downside is much lower than in the previous two super cycles.

Can massive, coordinated monetary and fiscal response by governments around the world make this cycle turn out better than past cycles? This question is a challenge to commenters to add some value to the discussion. Please try to limit political invective and finger pointing. Can we have a discussion looking forward, as painful as that may be?