Robert Arnott: Reversion To Which Mean?

Rob Arnott, founder of Research Affiliates, innovators of FTSE RAFI Fundamental Equity Indexes discusses the concept of 'reversion to the mean', but asks, ' which mean?'

Here are highlights:

Mean reversion is one of the most powerful and reliable drivers of long-term capital markets returns. It’s like a pendulum. When valuation levels get high (or low) by historical standards, they’ll usually swing back to past norms, often overshooting as a pendulum might. To be sure, mean reversion works its magic slowly, so one can often wait a long time for values to revert.

One challenge with relying on mean reversion is that we don’t know what the “right” mean is. Stocks today look cheap relative to the “mean” of the last 20 years, but expensive relative to the “mean” of the last 100 years. So, which is right?

About stocks:

Spreads between growth and value stocks widened to near record levels in March. Even now, deep value stocks are priced for a bleak outcome. If these prices are right, then the growth stocks are ridiculously expensive. If the growth stocks, which are priced to reflect an economic recovery in the next 6-12 months, are right, then deep value stocks are cheap.

About corporate bonds:

Investment grade corporate bonds also yield 2 per cent to 4 per cent more than the stocks of the companies that issued the bonds, so the bonds can beat the stocks if earnings and dividends grow slower than 2 per cent to 4 per cent. Over the past 50-100 years, earnings and dividends have grown about 4 per cent to 5 per cent a year, of which 3 per cent was inflation. This means stocks should edge past their own corporate bonds, unless the growth rate has changed.

Treasury inflation- protected securities represent a useful hedge against renewed inflation. And, they’re priced at a yield about 2 per cent lower than notional Treasury bond yield of the same maturity.

Government intervention is changing the landscape, and altering the market norms of last twenty years:

The market is trying to figure out what equity and bond ownership means in an order that chooses direct intervention over Adam Smith’s “invisible hand”.

Will this move towards centralised control deliver unintended consequences? Of course. The most obvious is that if secured bondholders are no longer assured of being “first payee” in bankruptcy, then bondholders will demand more reward to compensate for an unexpected new layer of risk. If stockholders are subject to expropriation, then stock prices will reflect a new layer of risk.

The most important consequence is whether centralised management of the economy will lead to improved economic growth. History suggests the contrary. So, the “mean” moves. But by how much? Ben Graham drew a distinction between price-based losses and a permanent loss of capital. The former represents a buying opportunity; the latter does not. We’re seeing more of the latter imposed on the capital markets – by government fiat – than we’ve seen in the past.

In other words, be careful and don't rely strictly on what you think you know about the market, nor your assumptions as to what you think the mean might be to guide you here. (Read the June 28, 2009 article here.)

Back in late April, we published the note, Bonds: Reversion Cuts Both Ways, in which Rob Arnott asserts that investors should take care to not make broad assumptions about which asset group will outperform over the long term. Arnott, who is the founder of FTSE RAFI Fundamental Indexes, willingly explains why he's been favouring bonds.

Suggestion: Get to know as much about the bond market, interest rates, and currency relationships as you can.

Here is some suggested reading (and viewing) from items we have covered that you may have missed:

Hugh Hendry: 10-year Treasury Signals Deflation

August 6, 2008 - Hendry points out that 10-year treasurys are up 15% YTD, and are signalling deflation - in the same segment, he also skewers Lloyd's Nick Hodson.

Hendry: Not Yet Time to Invest in Inflationary Assets

March 17, 2009 - Though Hendry appears to be wrong about investing in inflationary assets in the short term back in March, when the recovery rally started, his arguments are compelling, and he gets into an impassioned debate/argument with Liam Halligan over which side of the trade one should be on. Its enlightening and educational, because it highlights the debate between inflationists and deflationists.

Peter Thiel: Letter to Clarium Capital Partners

April 21, 2009 - Clarium's Managing Director, Patrick Wolff does an excellent and interesting job of explaining the credit market, Quantitative Easing, and among other things how it is and is not inflationary, given the consensus over the whirring of government printing presses. Believe it or not - the amount of money being printed may not be sufficient - yet.

Make Sure You Get This One Right

July 3, 2009 - Niels Jensen discusses the inflation/deflation debate and about what side of the trade investors should consider.

These are good start for now.

Source: FT.com, Robert Arnott, June 28, 2009