My prior post explored the ninth wonder of the world: reversion to the mean. Today, we continue the discussion on this phenomenon.
Forecasting stock returns is a more difficult task than forecasting bond returns. While the relationship only holds at long horizons, what we do know is that valuation metrics such as P/E ratios have had an inverse and mean-reverting relationship with future stock market returns. However, even over 10-year periods, P/E ratios explain only about 40 percent of the time variation in net-of-inflation returns. This is true whether or not trailing earnings are smoothed or cyclically adjusted (as is done in Robert Shiller's popular CAPE 10 ratio). With that said, you can see the relationship, and the tendency for returns and valuations to mean revert.
In a November 2012 paper, "An Old Friend: The Stock Market's Shiller P/E," Cliff Asness of AQR Capital found that 10-year forward average real returns fall nearly monotonically as starting CAPE 10 P/Es increase. He also found that as the starting Shiller CAPE 10 increased, worst cases get worse and best cases get weaker. And he found that while the metric provided valuable insights, there were still very wide dispersions of returns. For example:
- When the PE 10 was below 9.6, 10-year forward real returns averaged 10.3 percent. In relative terms, that is more than 50 percent above the historical average of 6.8 percent (9.8 percent nominal return less 3.0 percent inflation). The best 10-year real return was 17.5 percent. The worst was still a pretty good 4.8 percent real return, just 2.0 percent below the average, and 29 percent below it in relative terms. The dispersion between the best and worst outcomes was a 12.7 percent difference in real returns.
- When the PE 10 was between 15.7 and 17.3 (about its average of 16.5), the 10-year forward real return averaged 5.6 percent. The best and worst 10-year forward returns were 15.1 percent and 2.3 percent, respectively. The dispersion between the best and worst outcomes was a 12.8 percent difference in real returns.
- When the PE 10 was between 21.1 and 25.1, the 10-year forward real return averaged just 0.9 percent. The best 10-year forward real return was still 8.3 percent, above the historical average of 6.8. However, the worst 10-year forward real return was now -4.4 percent. The dispersion between the best and worst outcomes was a difference of 12.7 percent in real terms.
- When the PE 10 was above 25.1, the real return over the following 10 years averaged just 0.5 percent - virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills. The best 10-year real return was 6.3 percent, just 0.5 percent below the historical average. But, the worst 10-year real return was now -6.1 percent. The dispersion between the best and worst outcomes was a difference of 12.4 percent in real terms.
What can we learn from the above data? First, starting valuations clearly matter - and they matter a lot. Higher starting values mean that future expected returns are lower, and vice versa. However, there is still a wide dispersion of potential outcomes for which we must prepare when developing an investment plan.
What's the Mean to Which Returns and Valuations Revert?
I was recently at an investment conference at which the highly regarded Jeremy Grantham, chief investment strategist of Grantham, Mayo, Van Otterloo (GMO), a Boston-based asset management firm, was forecasting a bear market in stocks. Grantham cited the CAPE 10 ratio being about 50 percent above its 113-year mean of 16.5 and its median of 15.9. Grantham went on to note the market's strong tendency to RTM, saying it's only a question of when, not if. As of February 20, the CAPE 10 was 25.45. If it dropped immediately to its mean, the market would fall 35 percent. That's enough to scare off most investors - especially in light of the evidence Asness presented.
However, before you jump to any conclusions, consider the following. While the 113-year mean for the CAPE 10 is 16.5, its mean since 1960 is a much higher 19.6. This is important because there are logical reasons to believe that over time the risk premium investors demand from U.S. stocks should have fallen.
First, all else equal, the wealthier a nation, the lower the risk premium we should expect. Consider frontier markets, where capital is a very scarce resource. Economic theory tells us that the scarce resource earns the higher "economic rent." In addition, those countries typically have weaker regulatory environments in terms of investor protections. And it's often the case that foreign investors have even less protection than domestic ones. Thus, the cost of capital in such markets is very high - valuations are low and expected returns high. As those countries progress over time from frontier to emerging to developed, the cost of capital tends to fall as capital becomes less scarce and the regulatory environment is strengthened. Thus, it shouldn't be a surprise that the mean CAPE 10 has migrated higher over the past 50 plus years.