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

Testamentary trusts post-budget: Estate planning, tax reform and the ‘death tax’ debate

Proposed Budget changes to taxation are casting new uncertainty over testamentary trusts, prompting closer scrutiny of estate planning structures and the real implications of reforms still taking shape.

How to minimise tax with a will

Inheritance tax implications in Australia may surprise some, as poor estate planning without proper wills or trusts can lead to costly tax bills and delays for beneficiaries.

Meg on SMSFs: The CGT changes don’t impact super but what about Div 296 tax decisions?

New CGT rules could tip the scales in the super vs non-super debate. For those facing the Division 296 tax, the case for withdrawing has gotten more complex. A "comparison rate" tool may help assess decisions.

High quality businesses are on sale

Beneath the dominance of the ASX's largest stocks, much of the market has been left behind. High-quality companies are now trading at levels rarely seen, offering opportunities for investors willing to look deeper.

The strange effect of the 30% minimum capital gains tax

The 30% minimum tax on capital gains sits at the heart of the budget's proposed reforms. Yet the mechanics reveal anomalies that introduce unexpected distortions that raise questions about its design.

Welcome to Firstlinks Edition 667 with weekend update

The downfall of the giant and three lessons for investors.

  • 18 June 2026

Latest Updates

Latest from Morningstar

Ranking three common retirement strategies

The defining challenge of retirement isn't just about building wealth, it's about converting your lifetime savings into sustainable income. A holistic understanding of different strategies can improve long-term outcomes.

Economy

Was life really better in the good old days?

Are we worse off than previous generations? Lately, there seems to be a heightened level of angst that economic conditions are getting harder and that the two-party political system (and maybe democracy too) is failing voters.

Retirement

Australia has saved $4.5 trillion for retirement. Here's what matters more

Most Australians approaching retirement can tell you the exact dollar value of their super account. But success depends on more than a sizeable balance. Here's four key questions to ask yourself at the start of the financial year. 

Who gains in an AI-supercharged economy?

AI is already reshaping the economy, but companies building transformative technologies rarely capture the greatest long-term value. Instead, those benefits accrue to the users. We may well see this pattern reproduced. 

Taxation

Div 296's million-dollar reset worth $25,000

The 'cost base reset' for the new super tax is being sold as protection for pre-July gains. A worked example shows $1M of protection is worth about $25,000, and the real deadline has not passed.

Latest from Morningstar

The forecasting fix that Wall Street missed

Asking whether markets are overpriced may be the wrong question. New research suggests that traditional valuation metrics used to forecast returns may have been misread. Here are five takeaways for investors.

Investment strategies

Should a fund manager invest their own money differently?

Investors often like the idea that fund managers should invest client money exactly as they invest their own. But reality is more complicated. Unique circumstances make a different approach rational and, at times, beneficial.

Sponsors

Alliances

© 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.