Final hurdle for bull: a long drop

Mean reversion is a concept that sounds excruciatingly boring when it comes to playing the sharemarket but it is deadly accurate.

Fundamentally, the theory explains how highs and lows in a sharemarket, or any asset class, are temporary and will trend back to average over time.

For the most part, when we are in a bull market, we tend to ignore that we are travelling above the long-term average and in bear markets, we start to believe the world has changed forever and long-term trends are discarded to the rubbish bin. Mean reversion, though, is a powerful force and, when it comes to playing markets, investors are taking a major risk by ignoring it.

Most experts say we should not be hoodwinked into trying to pick market lows and market highs. The argument is that no one can pick a top or bottom and they are better off buying quality stocks with strong dividends and ride the wild swings of the market out.

Not only is this an abdication of duty, it equates to massive value destruction. Anyone who bought shares in 1969, 1987 or 2007 would have to wait more than a decade to get a positive after-inflation return, a result that retirees in particular just can't afford.

This takes us back to mean reversion. Over the course of more than 100 years, the Australian stock market has clocked up annual returns of slightly more than 7 per cent, not including dividends.

If we take November 1992, the end of the last secular bear market, as our base, then we can work out where we are in the current cycle.

Between 1992 and November 2007, the bench market All Ordinaries index rose at an annual rate of 11 per cent, some 4 per cent above the average. This means at the peak on November 1, 2007, the All Ordinaries index was about 43 per cent overvalued.

As stated by the mean reversion theory, the high point is fleeting and that 43 per cent was wiped out in the 2008 bloodbath. From that point onwards, it was a case of trying to find the bottom and how much the market would go below the average.

If again we take November 1992 as our base, the Australian market - about 4? years past its peak - is about 23 per cent below the mean. The question becomes, is that enough?

Two weeks ago, I wrote an upbeat piece detailing how I thought we were approaching the end of the current bear market. I argued that come late 2012, or possibly early 2013, the Australian market would finally finds its feet and start to rally for several years. I still firmly believe this scenario has a great chance of playing out.

For this prediction to have any legs though, the sharemarket needs to fall further into the back end of the year, testing the lows we experienced in August 2011 and quite possibly the 3100 mark touched in March 2009. This type of decline by the beginning of next year would result in the All Ordinaries index falling to about 45 per cent below its long-term average, equivalent to the amount it surged above the mean in 2007.

Why does the market need to fall further before it can end? Secular bear markets are fundamentally about two things - time and price. Over the past five years, every time the market has rallied, economic events have pulled the rug from under the feet of investors, causing a sharp decline in equity prices.

A comforting factor is that other asset classes are also, at last, experiencing mean reversion. Commodity and energy prices are starting to fall after a decade of trumping the mean. Following commodities closely is the depreciation of the Australian dollar, which will head towards its long-term mean of US75?.

Company and household debt levels are moving back to more normal levels. Housing prices abroad have already adjusted and, at last, the stubborn Australian residential market is heading towards a long-term average, even though it still has further to go.

The last pin to fall will be a savage reduction in historically high government debt levels, especially in the US. This will require a combination of significant spending cuts and a marked increase in taxation. The US economy will slip back into recession as the government share of the economy falls from about 25 per cent to the long-term average of about 19 per cent. Such action is painful but necessary to longer term prosperity for the world.

Previous bear markets, particularly in the US, have concluded with the overall market trading on single-digit price-to-earnings ratios, well below the long-term mean of closer to 14 times. The US market is trading in the mid-teens while Australia is mildly cheaper at about 12 times. While they may not get back to historic lows, the P/E ratios of both markets seem too high to conclude a bear market.

This all points to a tremendously difficult six months ahead of us, but once we get to a point well below the long-term mean, it will be the start of a long journey to the mean and beyond.