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.

 


 

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

Australian house prices close in on world record

Sydney is set to become the world’s most expensive city for housing over the next 12 months, a new report shows. Our other major cities aren’t far behind unless there are major changes to improve housing affordability.

The case for the $3 million super tax

The Government's proposed tax has copped a lot of flack though I think it's a reasonable approach to improve the long-term sustainability of superannuation and the retirement income system. Here’s why.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

The super tax and the defined benefits scandal

Australia's superannuation inequities date back to poor decisions made by Parliament two decades ago. If super for the wealthy needs resetting, so too does the defined benefits schemes for our public servants.

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Latest Updates

SMSF strategies

Meg on SMSFs: Withdrawing assets ahead of the $3m super tax

The super tax has caused an almighty scuffle, but for SMSFs impacted by the proposed tax, a big question remains: what should they do now? Here are ideas for those wanting to withdraw money from their SMSF.

Superannuation

The huge cost of super tax concessions

The current net annual cost of superannuation tax subsidies is around $40 billion, growing to more than $110 billion by 2060. These subsidies have always been bad policy, representing a waste of taxpayers' money.

Planning

How to avoid inheritance fights

Inspired by the papal conclave, this explores how families can avoid post-death drama through honest conversations, better planning, and trial runs - so there are no surprises when it really matters.

Superannuation

Super contribution splitting

Super contribution splitting allows couples to divide before-tax contributions to super between spouses, maximizing savings. It’s not for everyone, but in the right circumstances, it can be a smart strategy worth exploring.

Economy

Trump vs Powell: Who will blink first?

The US economy faces an unprecedented clash in leadership styles, but the President and Fed Chair could both take a lesson from the other. Not least because the fiscal and monetary authorities need to work together.

Gold

Credit cuts, rising risks, and the case for gold

Shares trade at steep valuations despite higher risks of a recession. Amid doubts that a 60/40 portfolio can still provide enough protection through times of market stress, gold's record shines bright.

Investment strategies

Buffett acolyte warns passive investors of mediocre future returns

While Chris Bloomstan doesn't have the track record of his hero, it's impressive nonetheless. And he's recently warned that today has uncanny resemblances to the 1990s tech bubble and US returns are likely to be disappointing.

Sponsors

Alliances

© 2025 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.