It's going to get worse before it gets better, but a long-term upswing is inevitable, writes Matthew Kidman.
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.
Frequently Asked Questions about this Article…
What is mean reversion and why does mean reversion matter for everyday investors?
Mean reversion is the idea that extreme highs and lows in any asset class tend to move back toward a long‑term average over time. For everyday investors it matters because markets that have run well above their historical norm can fall sharply, and markets that are well below the mean eventually recover. Ignoring mean reversion can expose investors—especially retirees—to long periods of poor real returns if they buy at peaks or assume the world has permanently changed during a bear market.
Is the Australian market still in a secular bear market and what evidence does the article give?
According to the article, the Australian market remains below its long‑term mean: using November 1992 as a base, the market was about 23% below the mean a few years after the 2007 peak. The author argues the market may need to fall further toward the lows seen in August 2011 or even the 3,100 level touched in March 2009 before a lasting recovery can begin.
Should everyday investors try to time the market or pick tops and bottoms?
Most experts say you shouldn’t try to pick market tops and bottoms because timing is extremely difficult. The article notes that many recommend buying quality stocks with strong dividends and riding out volatility, but also warns that blindly following that approach can lead to massive value destruction if you bought near historic highs. The piece highlights the risk of long waits for positive after‑inflation returns following major peaks.
How low might the All Ordinaries need to fall before a sustainable rebound, according to the article?
The article suggests the sharemarket may need to test the August 2011 lows and potentially fall to around the 3,100 mark seen in March 2009. A drop of that size would put the All Ordinaries about 45% below its long‑term average—roughly the mirror of how far it surged above the mean in 2007—before the start of a sustained recovery.
What role do commodities, energy prices and the Australian dollar play in market mean reversion?
The article points out that commodities and energy prices are finally reverting toward their long‑term means after a decade of outperformance. That decline is linked with depreciation in the Australian dollar, which the author expects to head back toward a long‑term mean of about US$0.75. These adjustments across asset classes are part of the broader mean‑reversion process.
How do government debt levels and US fiscal policy affect the outlook for markets?
High government debt—particularly in the US—is cited as one of the final areas that must revert to more normal levels. The article says reducing historically high government debt will likely require significant spending cuts and higher taxes, which could push the US economy into recession in the near term. That process would be painful but is presented as necessary for long‑term global prosperity and market stability.
What do historical returns and valuation metrics (P/E ratios) say about current market valuations?
Over more than 100 years, the Australian stock market has averaged a little more than 7% annual returns excluding dividends. Historically, bear markets in the US finished with overall market P/E ratios in the single digits, versus a long‑term mean nearer 14x. At the time of the article, the US market was trading in the mid‑teens P/E while Australia was mildly cheaper at about 12x—levels the author suggests are still too high to declare the bear market over.
What should everyday investors expect in the months ahead, based on the article’s outlook?
The article warns of a tough six months ahead: markets may need to fall further below the long‑term mean before a durable recovery begins. The author remains cautiously optimistic that if the market reaches those deeper lows it could start a multi‑year rally possibly beginning in late 2012 or early 2013, but only if the market first completes the mean‑reversion process.
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