Last Updated July 21, 2015
Stock market valuation mean reversion, or less technically, the tendency of stock market valuation ratios to stay relatively close to their long-term average, is one of the most important concepts in my investment framework.
Without mean reversion the market would never be expensive or cheap, and beating the market may be impossible. Fortunately for those of us who are active investors, valuation mean reversion does exist.
The result is that sometimes the market is obviously expensive and sometimes it is obviously cheap (although for much of the time it is neither).
Investors who understand this can buy low and sell high, with some confidence that they will be rewarded for doing so.
Which valuation ratios mean revert?
Pretty much all of them. It doesn’t matter whether you’re looking at price to earnings ratios, price to book ratios, price to sales, price to 10-year average earnings ratios (PE10), the Cyclically Adjusted PE ratio (CAPE) or the dividend yield.
They all mean revert in the long-run.
One caveat though is that I’m talking about the valuation ratios of the market as a whole, which is typically defined as a market index like the FTSE 100 or FTSE All-Share.
The ratios of one particular company may not mean revert because, for example, it might go bust (which is unlikely to happen to the FTSE 100 unless nuclear war breaks out, in which case your investments are the least of your worries).
Why do (market) valuation ratios mean revert?
One way to explain valuation mean reversion is to look instead at profit margins, which are another financial metric with mean reverting tendencies.
If a company or industry produces high profit margins, other profit maximising companies will want a piece of the action. Those other companies will invest their capital (equipment and/or people) into whatever areas are producing high profit margins in order to capture them as well.
This extra competition will reduce profit margins until they are no longer so attractive. High profit margins are therefore driven down by the profit seeking capital allocation decisions of managers and entrepreneurs.
On the other hand, low margins will see firms move out of an industry or go bust. This helps to reduce competitive pressure and widen profit margins for those who remain, assuming the industry as a whole doesn’t become obsolete.
So profit margin mean reversion is driven by companies deciding where they should apply their capital to maximise profits. Of course I’ve skipped over a lot of detail there, but the basic idea has held up very well over long periods of time.
The same sort of profit maximising forces drive stock market valuation mean reversion as well.
Stock market valuations are anchored to the replacement value of the underlying businesses (the ratio between these two values is sometimes referred to as Tobin’s q).
If stock market values are much higher than replacement value then it’s rational for investors to want to build a new business from scratch rather than buy one in the stock market.
This puts downward pressure on stock market valuations because it reduces the supply of investors willing to buy shares rather than invest in new companies.
The opposite case holds when stock market values are far below replacement value. Why build a new company when you can buy an existing one more cheaply in the stock market?
This increases the number of investors willing to buy shares in existing companies rather than start new ones, and this puts upward pressure on stock market valuations.
Implications for future stock market returns
This simple idea of supply and demand is why we can be pretty sure that the FTSE 100’s CAPE (my preferred valuation ratio for market indices) will never reach one million, and it’s unlikely to fall to one.
CAPE may go up to 90 (Japan, 1990) or down to 5 (USA, 1932), but at some point the investment decisions of managers, entrepreneurs and investors will drive valuations back towards the replacement value of the underlying businesses.
For many countries replacement value translates into a CAPE somewhere between 10 and 20, with the global long-term mean CAPE around 17.5. You probably won’t go too far wrong if you work on the assumption that, a few years from now, the stock market will be at a level where CAPE is in the mid-teens.
The implication of that simple assumption is profound:
When the FTSE 100’s CAPE is far below its long-term average – Future returns are likely to be higher than normal, due to higher dividend yields and higher capital growth as the market’s value mean reverts (upwards) towards its long-term average.
When the FTSE 100’s CAPE is far above its long-term average – Future returns are likely to be lower than normal, due to lower dividend yields and lower (or negative) capital growth as the market’s value mean reverts (downward) towards its long-term average.