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Sir Francis’ Inadvertent Gift to Value Investors
The folklore of investment and financial markets is full of catchcries such as “buy low and sell high.” Many are variations on a simple theme: if you allocate your investment capital in a manner consistent with the assumption that the tightly-circumscribed bounds of normality revealed over the twentieth century (i.e., the average annualised return on listed Australian equity over the past 100 years is 9.6% and has a standard deviation of 1.6%) extend into the future, then you will accumulate wealth sooner and face a smaller risk of permanent loss of capital than if you run with today’s crowd and this month’s fad. Yet many and probably most market participants violate this principle every day.
For whatever reason, and as Ben Graham’s parable of Mr Market shows, they are emotionally incapable of insulating themselves from their emotions and embracing their faculties of reason. Instead, comforted by conformity and bedevilled by greed and fear, they run with the crowd and do not stop, clear their minds of detritus and think for themselves. Seemingly for psychological reasons, then, it is hard to keep Sir Francis, his pea pods and the principle of regression to the mean in plain view. Even though we never know what is going to happen tomorrow, let alone next year, it seems to be easier to focus upon and plan for the next day than for the more distant future.
From this tendency follows another: the proclivity to assume that tomorrow, the next day and the day thereafter will resemble today, i.e., to focus upon recent events and “case rates” rather than long-term trends and “base rates.” In 1930-32 and 1973-74, then, the assumption was that the storm would never end; and in the late 1920s and late 1990s the assumption was that inclement conditions could never appear. Hence the tendency to lose sight of Sir Francis’s priceless gift to investors: the likelihood that investment results obtained tomorrow and into the more indefinite future will more closely resemble the average of results obtained over the past one hundred years than the results obtained today and yesterday. The negative extremes of the Great Depression and the 1970s were unsustainable and subsequently regressed upwards towards historical averages. The positive extremes of the late 1920s and late 1990s were also unsustainable, and subsequently regressed (or are in the process of regressing) downwards towards those same historical averages.
This latter point helps to clarify much of what is presently discombobulating many market participants. In the words of Barrie Dunstan (The Weekend Australian Financial Review, 4-5 May), “what is happening is probably a drawn-out phase during which overpriced stocks of all types are coming back to earth … Forget about projections of economic growth in the United States or elsewhere. Stockmarkets at the moment aren’t about business prospects; they’re about the excessive valuations investors have been placing on shares. These valuations went far too high until early 2000. Now they are in the process of adjusting in what the experts call ‘reversion to the mean.’” According to Robert Fuller (cited by Dunstan), “you won’t hear much about reversion to the mean from investment managers – one never does when they are on the wrong side of it – but the process is one of the most logical and predictable long-term cyclical developments in markets.”
Regression to the Mean in Financial Markets
Investors such as David Dreman and behavioural economists such as Richard Thaler and Werner De Bondt have uncovered strong evidence that regression to the mean, or something akin to it, occurs on financial markets. It occurs at both individual and aggregate levels, i.e., with respect to both individual securities and markets as a whole. Using data for the period 1926-1982, Thaler and De Bondt studied the securities of those companies whose prices over a three-year interval had either increased or decreased more than the market average. They found that “extreme returns of stocks listed on the New York Stock Exchange were subsequently followed by significant price movement in the opposite direction.”
If investors are either unduly optimistic or pessimistic about a particular company’s securities, and if that company’s fundamentals remain unchanged, then their stance will likely be reversed over time. Very fashionable stocks and market segments thus become less exalted, and highly unfashionable companies and sectors return to average favour. Dreman in particular has demonstrated how the crowd’s exaggerated reactions, unwittingly aided and abetted by the mass media, occasionally offer tremendous investment opportunities to those who are prepared to stand apart from the crowd.
If the price of a financially sound company’s stock is savaged by pessimistic investors, mass media coverage and commentary to the point where it falls considerably below its intrinsic value, then – as long as the company’s operations and prospects remain sound – the price of its securities will eventually recover. Conversely, if a company’s shares are inflated above their intrinsic value by euphoric (or simply commission-based) brokers, advisors and media supporters, then – even when its operations and prospects remain unchanged – at some point it will fall from its exalted status.
Although DeBondt and Thaler’s test methods have been subjected to some criticism, their findings have been confirmed by others using different methods. When investors overreact to new information and ignore long-term trends, regression to the mean turns the average winner into a loser and the average loser into a winner. This reversal tends to develop with some delay, and this delay creates opportunities for alert entrepreneurs. It appears that at first buyers and sellers overreact to short-term news and then underreact whilst awaiting additional short-term news of a different character. As with peas in a pod, so too with companies: it could not be otherwise. If it were, i.e., if the winners kept on winning and the losers kept on losing, then the economic and financial landscape would consist of a shrinking handful of companies with colossal market capitalisations and virtually no small enterprises.
The Market as a Whole
If the DeBondt-Thaler hypothesis of overreaction to recent news applies to the market as a whole and not just to individual stocks, then regression to the mean should manifest itself as longer-term realities make themselves felt. If, on the other hand, investors are more fearful in some economic environments than in others – say, 1932 or 1974 in contrast to 1968, 1986 or 1999 – stock prices would fall as long as investors are afraid and would rise again when circumstances changed and justified a rosier view of the future. Both possibilities suggest a Graham-like stance vis-à-vis the broader financial market, market news and other market participants: one should ignore short-term volatility, discount the latest news and disregard “case rates” and concentrate upon “base rates” enduring developments and phenomena such as regression to the mean. To do so is to ignore the crowd, embrace Emersonian self-reliance and hold for the long term.
A More Recent Study
The applicability to financial markets of regression to the mean is thus a salutary reminder that at critical junctures the mass media and the crowd are mistaken. At these junctures their views do not reflect reality, but rather exaggerated (i.e., unduly optimistic or pessimistic) perceptions of that reality. This simple but profound notion was recognised at least 2,000 years ago. (Horace, the Latin lyric poet and satirist, wrote in his Ars Poetica that “many shall be restored that now are fallen; and many shall fall that now are in honour”). Today, however, it appears either that market participants have forgotten it or that their methods obscure it.
The remarkable levitation of financial markets during the closing years of the twentieth century prompted economists John Campbell of Harvard University and Robert Shiller of Yale University to revisit a topic they discussed in a 1998 paper based upon their joint testimony before the Federal Reserve’s Board of Governors in 1996. Their revised paper is entitled “Valuation Ratios and the Long-Run Stock Market Outlook: An Update.” Using annual data from 1871 to 2000 and quarterly data for twelve major countries since 1970, Campbell and Shiller (author of Market Volatility, MIT Press, reprint edition 1992, ISBN: 0262691515; and Irrational Exuberance, Broadway Books, 2001, ISBN: 0767907183) examined price-to-earnings and dividend-to-price ratios as forecasting variables. In their words, “various simple efficient-markets models of financial markets imply that these ratios should be useful in forecasting future dividend growth, future earnings growth or future productivity growth.”
They find, however, that “overall, the ratios do poorly in forecasting any of these. Rather, the ratios appear to be useful primarily in forecasting future stock-price changes, contrary to the simple efficient-markets models … When stock-market valuation ratios are at extreme levels by historical standards, as dividend/price and price/earnings ratios have been for some years in the U.S., one naturally wonders what this means for the stock-market outlook. It seems reasonable to suspect that prices are not likely ever to drift too far from their normal levels relative to indicators of fundamental value, such as dividends or earnings.” Hence the simple reversion-to-the-mean theory: “when stock prices are very high, relative to these indicators, as they have been recently, then prices will eventually fall in the future to bring the ratios back to more normal historical levels.” Indeed, and as Campbell and Shiller testified in 1996, “despite all the evidence that stock returns are hard to forecast in the short run, this simple theory of mean reversion is basically right and does indeed imply a poor long-run stock-market outlook.”
A Conclusion and Three Cautions
The simple and powerful notion of regression to the mean provides the underpinning of many decision-making systems. And for good reason: there are few situations when large things continue without interruption to become infinitely large and small things become infinitesimally small. Trees grow upwards but never reach the heavens. Accordingly, when we are tempted – as we so often are – to extrapolate past trends into the future, we should remember the genetics of Sir Francis’s humble sweet peas.
Yet if regression to the mean follows such a constant pattern, why is forecasting such a frustrating (and ultimately useless) activity? The simplest answer is that the forces at work in nature are not the same as the forces at work between people’s ears. The accuracy of most forecasts depends upon decisions made by people rather than Mother Nature; and nature, with all its vagaries, is much more dependable than an individual or committee of individuals trying to make a decision.
Accordingly, there are three reasons (Peter Bernstein, Against the Gods: The Remarkable Story of Risk, John Wiley & Sons, 1998, ISBN: 0471295639) why regression to the mean can be a fallible and frustrating guide to decision-making. First, sometimes regression proceeds at such a slow pace that an exogenous “shock” will disrupt or reverse it. Second, the regression may be so strong that matters do not come to rest once they reach the mean; rather, they “overshoot” before fluctuating irregularly around the mean. Finally, and perhaps most importantly, the mean itself may be unstable, so that yesterday’s normality may be supplanted today by a new normality that we cannot anticipate and know little or nothing about.
 
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