Using Historical Averages Can Make Money in Stocks

A concept that I’ve explored lately in this recent volatile market is reversion to the mean, which suggests that prices have a tendency of eventually moving back towards their long-term historic averages.

A good example of this could be the price of oil. After rising 47% in the first half 2008 and hitting a record high of $147 per barrel on July 11, the price of oil has dropped more than 20% in less than eight weeks as supply-demand dynamics adjusted (Not including the speculative bounce last week). Albeit $120 oil can still be considered high by historical standards, the point is that dramatic increases over short periods of time represent imbalances that are likely to self-correct.

Using The Reversion Theory In Your Portfolio

Within the context of recent history, many people might associate reversion with a downward movement so the first thing that comes to mind is something that’s overpriced. However, if we turn this concept over in order to highlight value as well. For example, while oil has soared to new heights, at the other end of the spectrum global equities have been punished and U.S. stocks in particular have struggled amid the credit crunch and a deteriorating economic backdrop.

Over the last 12 months, the return on the S&P 500 Index has been about -11%. Consider however that the average annual return on U.S equities over the past 25 years is 11.4%. On this basis, investors (especially those sitting on the sidelines in cash) might want to ask themselves whether they think stock prices in the world’s largest and most diverse economy will stay at current levels indefinitely, or whether it’s more reasonable to think that at some point, they’ll revert to more historically normal levels.

Analysts spend many hours and a boat-load of money determining what they perceive as fair value for equity markets. Their valuation models incorporate long run averages for inflation, interest rates and growth and based on current levels for these factors, U.S. equities appear to be trading below fair value. Another way to interpret the reversion theory essentially is a version of the “stocks on sale” message.

Reverting To Positive Returns

If U.S. equities are trading below where they should be based on historic averages for similar environments, then it follows that at some point, they should move back towards fair value, meaning stock prices should eventually rise.

Now, I am NOT forecasting what the price of oil will be or where U.S. stocks will be trading six months from now or when reversion will happen - I’ll leave that to the “experts” . The message to take from this is that amid 200 point swings in the stock market or $10 spikes in oil prices, it’s prudent to think about where prices are in relation to historic long run averages.

In a volatile market is becomes very difficult to predict which individual stocks are going to be most successful.  However, buying a broad index such as the S&P 500 will offer significant exposure to a US equity market that has become oversold and is valued at well below historical averages.  Not to mention that the S&P 500 has a dividend growth rate of about 11%.  So, buying this index offers you an average of 11% raise each year while we wait for valuations to return to the mean.

Comments

[David Martin:]

Taleb in the 'Black Swan' comments on this sort of thinking - or rather not thinking, as it relies on normative behaviour and does not look for the critical turning points.
That is how the insurance industry has lost billions.
Perhaps it has not occurred to the author that oil is a real, physical commodity, and that supplies are not infinite and so at some stage it will become more expensive and difficult to find?
Or that this will gravely impact a society based on cheap energy?

2008 Aug 26 08:40 AM

[Foolish reader:]

Perhaps that is why this website is called Seeking Alpha

2008 Aug 26 09:34 AM

[razorfangius:]

It's funny to pitch a mean-reversion theory that involves eyeballing an oil chart and saying "this is too high", and then caveat by saying "I am NOT predicting where the price of oil is going to be."

So you are proposing that people use a strategy that you yourself have no confidence in?

Actually what do you even mean by averages? 50 day? 200 day? 5 year? 75 year?

The 75 year average price of oil is probably $4 a barrel ... the 50 day average is probably $130. So the price of oil is out of line compared to what??

2008 Aug 26 09:46 AM

[irondoor91:]

When looking at stock market returns, the past 25 years will likely turn out to be an anomaly. Since you make an issue of dividends, surely you must know that the dividend level today of slightly more than 2% is significantly smaller contributor to total return than it has been over the longer-term history of the market. "Way back when", stocks were considered much more risky than bonds and investors demanded compensation for their risk; thus the dividend yield was larger than bond interest yield.

In the past 30+ years as central banks have devalued their currencies and inflated the "nominal value" of paper assets, investors have become to accept that an ever-larger portion of their long-term return will come from capital appreciation vs. from dividends. In fact, the mantra has been that companies that pay dividends are somehow under-performing and investors have insisted that managements re-invest excess cash flows back into the business or use it for stock buy-backs. In a low interest rate environment, managements have levered up to buy back stock.

We now see where this has gotten us as it turns out it is all nothing but financial engineering. Our country's economic production strength has been sapped as companies transferred their manufacturing and production overseas, while perhaps keeping headquarters, sales and marketing here. This leveled out the fluctuations in US employment and transferred the risks of manufacturing slowdowns overseas. But, you can't transfer commerical and residential construction overseas, and since the American housing industry is the greatest absorber of liquidity and leverage upon leverage in the world, that's where much of the world's excess liquidity has gone in the past 7 years. Any why not, since American housing has never gone down in value (except in the Great Depression, of course).

As it all comes home to roost now, you will find reversion to the mean, all right. The stock market has the same problem as the housing market. Housing got to be overpriced and was pumped up with exotic financing, no money down, etc. It deviated to the extreme from its normal price of around 3 x annual family income. Since annual family income is approximately $50,000, the average natural price of single family housing is upwards of $150,000 per unit. It will get there eventually or the housing glut will never be absorbed. Either incomes are going up by 50% immediately or housing is going down immediately. Which do you think it will be?

The stock market is in the same boat and it will revert to its natural mean. It just isn't going to be in the direction that you propose, however. Either dividends will double while the price of the S&P remains constant or the S&P will have to decline to reprice to the natural yield of around 4%-5%. That should give us a market price of the S&P 500 somewhere in the range of about half of where it is today.

Another fly in the ointment is your assumption of an 11% annual dividend increase. As we continue into recession if not mini-depression, dividends will be cut (as they already are for the financials) and stocks will have to go even lower to reprice to the natural yield.

2008 Aug 26 12:12 PM

[Steven Hansen:]

in summary, the market is down. the market is within historical averages. the market will go up again. the experts will help us understand when again is. the market is volatile and individual stocks go up and down. so we should by an index stock. the end.

thanks.

2008 Aug 26 11:39 PM