WEDNESDAY JANUARY 6, 2010

The most powerful force in the universe!

What is the most powerful force in the universe?  Hurricane?  Volcano?  The slow and steady drip of water (think Grand Canyon!)?  The gravity of a black hole? I will let others debate this question. For investors, however, the most powerful force might just be mean reversion. Yep, the old bell shaped curve, the normal distribution. Statistics tell us that in a normal distribution, returns may vary around the mean, but will eventually revert back to the mean return over time. Over the last forty years, the S&P 500’s annualized compound mean return is 9.9%. And that is an important number for investors to consider in the aftermath of the 2000’s. 


Today, the media is filled with doomsday scenarios. And with good reason. High unemployment, financial crisis, massive budget deficits, terrorism, war…the list goes on. The talking heads on TV are quick to point out that, over the last ten years, the S&P 500 has posted an annualized compound return of -.95%. That’s right, a negative .95%! The pundits are once again declaring the end of equity investing. And investors are heeding the siren call, as investments in money market instruments and bonds remain at historically high levels. There is still $3.5 trillion in money market funds! But the market has been here before, and the power of mean reversion has seized the day.

 

Like today, the 1970’s were an ugly period for the economy and the markets. The decade was marked by double digit unemployment, record high inflation and interest rates in the high teens. Money market instruments yielded above 20% and mortgage rates were 18%! The Iran Hostage crisis and the Arab Oil Embargo were the geo-political events of the day. Not surprisingly, the S&P 500 had an anemic 5.87% annualized compound return for the decade, well below the long-term average of 9.9%. At the end of 1979, few pundits held optimistic forecasts for the 80’s. Indeed, the August 13, 1979 Business Week cover story was entitled “The Death of Equities.” Yet, over the next ten years, the S&P 500 posted a remarkable annualized compound return of 17.53%. For the 20 years ending 1989, the market’s return was 11.55%, pretty darn close to the long-term mean return. Despite the doomsday forecasts, the roaring 80’s made up the paltry 70’s. Reversion to the mean!

 

We know that the 80’s bull market continued into the 90’s. The 10 year return for the 90’s was 18.17% and the 20 years ending 1999 posted an astonishing 17.85%! The roaring bull market had more than made up for the woeful 70’s, it overcompensated for it! For the 30 years ending 1999, the annualized compound return was 13.72%, significantly higher than the long-term mean. The media was filled with optimistic forecasts that spoke of the “new paradigm” and Dow 36,000! But mean reversion is a double edge sword!

 

The historic bull market’s 30 year return of 13.5% suggested that the market would need to correct to bring the long-term averages back to the mean. The negative 10 year return of the 2000’s reverted returns back to the mean with vengeance! For the 20 years ending 2009, the annualized compound return for the S&P 500 is a below average 8.19%. The 2000’s, with the bursting Dot.com bubble early and the financial crisis late, made up for the excesses of the late 90’s. Mean reversion once again.

 

That brings us back to today. In the media, pundits cite the negative 10 year return as a reason to abandon the equity markets, just like they did at the end of the 70’s. I would suggest the opposite. Now is the time to get into equities. The below average 20 year return of 8.19% indicates that the market needs to perform well if it is to revert back to the mean of 9.9%. With the last 10 years posting -.95%, the next 10 years, the “twenty-teens” will need to earn an annualized compound return in excess of an annualized 12% just to get back to the mean of 9.9%. That’s a pretty good return.

 

Mean reversion. The most powerful force in the universe!  Ignore it at your peril.

POSTED AT 1899-12-30 08:55:00.0

KEN ENTENMANN, CFA
SENIOR VICE PRESIDENT AND
THE DIRECTOR OF INVESTMENT MANAGEMENT SERVICES

Ken is a Senior Vice President and the Director of the Trust and Investment Services at Alliance Bank, N.A. He has 23 years of investment experience and oversees the management of assets totaling $1 billion. He holds a B.S. in Applied Economics and Business Management from Cornell University and an M.B.A. from the William E. Simon Graduate School of Business Administration at the University of Rochester. He has also earned his Chartered Financial Analyst designation. He is a member of the Executive Committee of the Trust Division of the New York Banker's Association. He is also a director of the Central New York Community Foundation.

RECENT POSTS

Targeted and Temporary


Better Unemployment Number


The "Safety of Bonds" Myth


Just like that!


Ugly August


Bright Side of Double Dip Fears


All eyes on Wyoming


Lack of Business Confidence


Are bonds forecasting a double dip?


Are rates too high?

The opinions expressed here do not represent the views of Alliance Financial Corporation and Alliance Bank, N.A. This communication is not an offer or solicitation for the purchase or sale of any security, is for general informational purposes only and does not provide personalized investment advice. When making personal investment decisions you should consult your investment adviser or rely on your own research. Copyright 2008.