Caution: Mean Reversion Ahead
The comments below are an edited and abridged synopsis of an article by Michael Liebowitz and Jack Scott
Investors are being urged to buy stocks because of low yields in the bond markets. While the advice may seem logical, many professionals fail to provide investors with a mathematical analysis of their expected returns for the stock markets.
Mean reversion is an important financial concept. The simple logic behind mean reversion is that market returns over long periods will fluctuate around their historical average. If you accept that a security or market tends to revolve around its mean or a trend line over time, then periods of above normal returns must be met with periods of below normal returns.
If professionals understood the power of mean reversion, they would likely be more enthusiastic about locking in a 2% bond yield for the next decade.
Liebowitz and Scott discuss expected bond returns and equity expected returns, and summarize as follows:
“As the saying goes, you can’t predict the future, but you can prepare for it. As investors, we can form expectations based on a number of factors and adjust our risk and investment thesis as we learn more.”
“Mean reversion promises a period of below average returns. Whether such an adjustment happens over a few months as occurred in 1987 or takes years, is debatable. It is also uncertain when that adjustment process will occur. What is not debatable is that those aware of this inevitability can be on the lookout for signs mean reversion is upon us and take appropriate action. The analysis above offers some substantial clues, as does the recent equity market return profile. In the 20 months from May 2016 to January 2018, the S&P 500 delivered annualized total returns of 21.9%. In the 20 months since January 2018, it has delivered annualized total returns of 5.5% with significantly higher volatility. That certainly does not inspire confidence in the outlook for equity market returns.”
“We remind you that a bond yielding 2% for the next ten years will produce a 40%+ outperformance versus a stock losing 2% for the next ten years. Low yields may be off-putting, but our expectations for returns should be greatly tempered given the outperformance of both bonds and stocks over the years past. Said differently, expect some lean years ahead.”