You're a Mean Reversion, Mr. Grinch
August 2, 2019
By Mike Moreland
Vice President Investments
In reviewing mid-year reports for clients, one item that stands out is the strength of the equity markets over the last decade. U.S. stocks showed annual gains in the mid-teens, and global markets exceeded double digits. Not many times in history were as rewarding as this.
Of course, these gains weren’t in a straight line. And importantly, the starting point was within weeks of the credit crisis trough – the broad market averages lost about half their value over the previous year or so. Still, few expected the results generated over the next 10 years. Consistent, diversified investors reaped the rewards of the recovery.
After a Decade of Historic Growth, What Will the Stock Market Do Next?
So what will the next decade bring? Nobel-winning physicist Niels Bohr once said, “Prediction is very difficult, especially about the future.” At the same time, there are principles that can shine light on the path. One is called “reversion to the mean” – the tendency for returns to migrate toward their long term averages.
Stock markets generally advance in line with nominal GDP (the sum of economic growth and inflation) over the long term – and long term means decades. This suggests average returns over time in the mid-upper single digits. Extended periods above or below this central tendency are followed by ‘catch-up’ phases that pull markets back toward the mean. Periods of unusually high returns are followed by periods of more subdued results, and vice versa. But where is the turning point and what should we expect? No one knows, but there are clues.
Let’s look at today. One of the best predictors of future performance is valuation at the starting point. A decade ago, stocks were close to Depression-level valuation and sentiment was awful; the path of least resistance was up. Today, not so much. The chart below, from J.P. Morgan’s Guide to the Markets, shows the relationship between beginning valuations and returns over time. Stocks are not cheap today, which may dampen future returns. While the potential range of results is wide, the most likely outcome is something around the long term average – mid- to upper-single digits.
Vanguard’s Investment Strategy Group uses a broader methodology and reaches a slightly more pessimistic conclusion. Following a decade of outsized gains for financial assets, Vanguard expects low- to mid-single digit stock performance in the next 10 years, and bond returns essentially in line with inflation.
Quite a change from the last decade, but absolutely consistent with the concept of reversion to the mean. Remember that valuation is only one of many variables that guide market behavior and, famously, it is not a timing device. It is, however, an important consideration in building general expectations for the times ahead.
This brings us to our relationship with you. Our task is to help you reach your financial goals. We will help you examine a range of possible outcomes, based on conservative projections. We will develop and manage a portfolio with the best combination of reward potential and risk control for your circumstances. And we do not draw a straight line from the past into the future. Talk to an Advisor today about how we can help you in the years ahead.