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Reversion to the Mean

I wanted to follow up on an article in the NYT yesterday on Jeremy Siegel, the uber-bull prof.  at U Penn., investment adviser at WisdomTree and author of 1994's top charting book: Stocks for the Long Run.  His premise to keep a healthly amount of your assets in stocks goes like this:  You should always be invested in stocks because, as the data has shown, stocks outperform all other assets classes over the long term.  Siegel believes in "reversion to the mean", in that stocks, over time, gravitate back to their historical average valuations.  Siegel uses historical price data going back to 1802 to calculate his returns (who knew anyone was even keeping tabs on this stuff back then?) and therein lies the problem.  Clean data.  Jason Zweig at the NYT put it like this last year on this very topic:

Prof. Siegel based his early numbers on data first gathered decades ago by two economists, Walter Buckingham Smith and Arthur Harrison Cole.

For the years 1802 through 1820, Profs. Smith and Cole collected prices on three dozen banking, insurance, transportation and other stocks -- but ended up including only seven, all banks, in their stock-market index. Through 1845, they tracked 19 insurance stocks, but rejected 95% of them, adding only one to their index. For 1834 onward, they added a maximum of 27 railroad stocks.

To be a good measure of stock returns, an index should be comprehensive (by including many stocks) and representative (by including the stocks commonly held by investors). The Smith and Cole indexes are neither, as the professors signaled in their 1935 book, "Fluctuations in American Business." They cherry-picked their indexes by throwing out any stock that didn't survive for the whole period, whose share prices were too hard to find or whose returns seemed "inflexible," "erratic," or "non-typical."

The database of early U.S. securities at has so far identified more than 1,000 stocks that were listed on 10 different exchanges -- including Charleston, S.C., New Orleans, and Norfolk, Va. -- between 1790 and 1860. Thus the indexes relied on by Prof. Siegel exclude 97% of all the stocks that existed in the earliest years of the U.S. market, and include only the bluest of the blue-chip survivors. Never mind all of the canals, wooden turnpikes, rubber-hat companies and the other doomed stocks that investors lost millions on -- and whose returns may never be reconstructed.




I have other issues, though, when historical returns for market indices are quoted, though.  I do think there is an apples to oranges comparison when looking at pre, lets call it "information age" pricing vs. data from the last 50 years or so. The advent of the computer and its application to all facets of the investment industry has had a profound impact on the way financial information is exchanged and processed, immensely speeding up the decision making process for market participants. It also increased the number of market participants to include more individual investors as well as bring more non-U.S. entities into the markets. I also believe other factors such as liquidity, securitization, regulation have all had an impact on the risk premium for stocks.  Really, who's to say that 15-16 x PE ratios are an appropriate "mean" given the world wide collapse of the markets in the past few years? And, even more so, with serious economic headwinds resulting from the current de-leveraging process, I find it difficult to incorporate "reversion to the mean" prices and valuation for the next few years.  That, however, is precisely what Siegel is proposing:

What’s more, when stocks are cheaper than average, as measured by the price-to-earnings ratio, positive returns became more probable in subsequent years. That is very encouraging for the current market, in which earnings have been rising despite widespread skepticism, keeping the P/E of the Standard & Poor’s 500-stock index at a modest level. Based on consensus estimates, it stands at 13. That compares with an annual average of 15.2 since 1945, he said.

If post-World War II patterns hold for the future, he calculated last week, prospects for stock investments are excellent: there would be a 96.6 percent probability of a positive return for the next 5 years, going up to 100 percent for 10- and 20-year periods. Average real returns would be stellar — about 11 percent annually in holding periods from 1 to 20 years.


Sorry, professor, blind faith in regression analysis and 20 year time horizons doesn't always work when 27 year olds were buying house after house in SoCal and Las Vegas, leveraged through the roof, and every private equity deal under the sun could get done regardless of the company's economic prospects. Lest we forget Prof. Siegel's words of wisdom in the summer of 2007 just before the you-know-what hit the fan:

Jeremy Siegel Says Get Ready to Buy

By Gregg Greenberg 08/10/07 - 11:55 AM EDT

The "Wizard of Wharton" says don't worry.

"If investors have cash on the sidelines, they should not wait too long to put it to use," says Jeremy Siegel, Wharton business school professor at the University of Pennsylvania and well-known markets commentator. "There are good values out there in equities -- especially in financial stocks -- and you will be rewarded in the long run if you start dollar cost-averaging now."


Oh wait, he's a director at WisdomTree, an EQUITY ETF management company. I forgot about that. All is forgiven professor.

Disclosure: No positions