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This is mean (-reverting that is)

Mean reversion: A theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry. (Source: Investopedia).

Investors are currently enjoying the fruits of an extreme event. Let’s begin with a quote from an excellent interview given by Ken Henry to Fairfax Media recently. When asked about investors’ current preference for yield, and the consequences of this behaviour, Henry responded first by noting that the popularity of yield chasing is “typical of periods of low inflation and high rates of savings.” He added however, “… it is also worth recalling earlier episodes of investor herd behaviour.”

Recalling the unfolding of the tech boom, Henry noted that the period was also one marked by high savings and low inflation but one where hoped-for productivity improvements turned out to be illusory. Furthermore, Henry noted that the years prior to the GFC were similarly characterised by low inflation and high savings, triggering a pursuit for yield (in securities backed by subprime loans) that “turned out not to be there”.

Weak domestic conditions

There is a risk that profits supporting the dividends of companies may turn out not to be there. Note the current suite of weak domestic economic indicators, which we have previously alerted investors to and which Ken Henry also cited:

  • the NAB Survey of Business Confidence has turned down
  • half a decade of flat non-mining investment, which is also reflected in weak business credit growth
  • unemployment higher than during the GFC, also reflected in the weak and still weakening Westpac and Melbourne Institute Index of Consumer Sentiment.

CLSA analyst Christopher Wood, who notably advised clients to sell mortgage-backed securities prior to the subprime crisis (we count ourselves among those advisers who also warned investors at the time), said Australian economic conditions will warrant rates of less than 1% “within the next two years”.

Ken Henry seems to concur noting, “... other risks worth building into scenario planning include: volatility in energy prices; slower growth in our major trading partners, especially China; global deflation and prolonged economic stagnation…”

CommSec’s recent review of the ASX Top 200 stocks revealed flat revenue growth and a 26% decline in profits over the six months to December 31, 2014.

Meanwhile, there exists ample evidence that these conditions - forcing yield-needy investors out of term deposits and into shares – have pushed valuations to extremes.

Market is on the expensive side

In the US, many note that P/E ratios of 18 times trailing earnings are far below post war records of 30 times, even though they are higher than 74% of observations since 1945. But while P/E ratios which stole the headlines prior to the GFC and the tech wreck are not currently at extremes, median valuations are climbing to post war records with stealth.

When the S&P 500’s P/E multiple is only slightly above average, but the median US stock is at a record high, the implication is that the valuation extreme is broad-based and is similar to the circumstances in 1962 and 1969.

Between 2012 and 2014, the overall US stock market, according to US fund manager Jim Paulsen, went from most stocks being priced only slightly above average to almost all stocks being priced near post-war records. As of June 2014, the median US stock was trading at a post war record of 20 times earnings. The median stock is also at a post war record price to cash flow of 15 times and the only time its price/book ratio has been exceeded was in 1969 and 1998 – periods that were both followed by substantial corrections. The implication is that US stocks are priced higher than is widely perceived.

While it can last for some time, and in the past has persisted for some years, when share prices disengage from their fundamentals, the situation is never permanent. There is no ‘permanently high plateau’ here, so watch for mean reversion.

Cash rates are low but cash is ammunition

What has complicated the outlook is that low interest rates might be with us for some time thanks to the same business conditions that are, ironically, causing people to rush into shares. A less-extreme event (a mean reversion) will follow, and that less-extreme event includes share prices returning to levels that reflect the threat to their weakening earnings.

The Montgomery Fund’s value model for a hypothetical portfolio of highly liquid, quality companies is suggesting the Australian market is slightly expensive compared to recent history. Our investment process is also producing a near-maximum cash weighting. After selling certain stocks recently, we aren’t able to find compelling alternatives to leaving money in cash. As a result we remain only about 75% invested. This puts us in a position to take advantage of lower prices if and when they occur.

The spread between share prices and their underlying drivers will mean-revert but as to when, the only logical advice I can offer other investors is to enjoy the party but dance very close to the door. If the herd rushes for the exits (and it may not for months or years) you will want to secure one of the few cabs waiting outside and join the revellers heading home to safety.

 

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. This article provides general information and does not address the personal circumstances of any individual.


 

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