Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 102

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.

 

  •   27 March 2015
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

The ASX's 16-year drought: a rebuttal

Where to put your money these days

Bubbles and the corruption of risk

banner

Most viewed in recent weeks

Why spending more in early retirement can improve lifetime income

Conventional wisdom encourages retirees to preserve superannuation. But if those likely to qualify for the Age Pension later in life spend a little more today, it may deliver higher lifetime income and a more stable retirement.

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

Testamentary trusts survived the trust tax. The drafting battle has just begun.

The fight over testamentary trusts looked settled. Then the draft legislation arrived. Hidden in a technical detail is a question that could force many families to rethink wills they thought were already future-proof.

Is it time to bail on Australian stocks?

For generations, Australian investors have backed banks, miners and dividends. But has that loyalty come at a cost? A look at the numbers raises an uncomfortable question about where future returns will come from.

The new capital gains tax trap for your portfolio

Investors have long accepted one portfolio rule without much question. A major tax shift could change that calculation entirely, forcing difficult trade-offs between risk, discipline and an overlooked cost lurking beneath.

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

Latest Updates

Fixed interest

Higher yields are creating opportunities in global bonds

Bond markets are adjusting to a new reality, but not in the ways investors expect. With markets repricing and capital competing for attention, investors may need to rethink where resilience and opportunity lie. 

Economy

Are we in a recession?

What if the warning signs are already everywhere? From supermarket aisles to company failures, investors are being bombarded with recession signals. But most face a different risk that can be just as dangerous for portfolios. 

SMSF strategies

Meg on SMSFs - Division 296 actuarial certificates

The tax bill might be yours, but the event that caused it may not be. A key Division 296 calculation can sometimes attribute earnings in ways that many SMSF trustees won't instinctively expect or fully appreciate.

Property

The first impact of negative gearing reform is not the tax bill

Negative gearing changes formally begin in 2027, but the first consequences may already be here. A subtle shift is quietly influencing who can borrow, how much they can access and which property strategies still stack up.

Economy

The oil market is running out of easy answers

The biggest threat to markets may not be what investors are watching. The numbers have stopped adding up and supply is harder to measure, with forecasts becoming simple guesses. A more fragile reality is being masked.

Investment strategies

The state of investor knowledge in Australia

Australians are investing more than ever, yet a surprising divide is emerging between those building wealth effectively and those making costly mistakes. Surprisingly, the gap has little to do with income, age or starting capital.

Taxation

Complexity and capital gains

A case study shows that the ‘30% minimum CGT’ is a poorly conceived tax that adds significant complexity to an already over-complex system. A less complicated model would create a much fairer progressive tax scale.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.