Reversion to the mean

Market cycles

Stocks don’t always go up, they continue to move in cycles, in turn becoming expensive and then cheap.

New ideas gain currency driving markets higher on the promise of future riches, until eventually the products and companies in question fail to deliver, whereupon valuations fall back to earth (often faster than they went up!).

Bear markets follow bull markets, and vice-versa, so with the benefit of hindsight it’s clear to see that when the market has been smashed that’s your cue to buy.

Fortunately, in the real world nobody invests all of their money at the market peak, and this doesn’t mean there’s no place for passive investing.

However, it is possible to generate better than average returns through the cycle, by recognising…

Macro valuations

There are many ways to determine whether a market is historically cheap or expensive, none of which can be totally reliable in isolation.

One of the more robust measures has been the Shiller PE or CAPE ratio, since it uses a smoothed average figure for earnings to iron out volatility and fluctuations in profit margins.

Although lower interest rates than in cycles past may somewhat justify a higher market valuation, the CAPE ratio has only once been higher than it is today, in the lead up to the tech wreck.

One of the challenges with using such ratios to predict cycles, is that – as you can see – crashes have happened from much lower valuations, while bull markets can also run for longer than you think.

Market timing

The above conundrum could lead you to the conclusion that trying to time the market is impossible or pointless.

On the other hand, there’s well over a century of available data to suggest that money invested when markets are cheap delivers outsized returns, while money invested at expensive valuations typically delivers only modest or negative results.

It’s also important to consider risk, since market drawdowns have, on average, been greater when markets are at an expensive phase in the cycle.

Managing exposure

Famous investor John Templeton said that the only investor that shouldn’t diversify is the one that’s right 100% of the time, and his approach was to reduce his allocation to stocks when markets became expensive.

A workable alternative approach is to hold some cash and look elsewhere for markets, sectors, and companies showing more attractive valuations.

Each stock market has its own cycle, and although markets have moved in a more synchronised manner since the 1980s, there’s sound evidence to show that investing on a global basis can be very positive for your portfolio.

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