Valuation models, like the CAPE ratio, are great for informing investors where the market stands. The models are meant to show how over or undervalued the market is in relation to its historical average. And if you believe that markets revert to a mean, then at some point any excess valuation will swing back to the norm.
Some people see valuation models as a timing tool except none actually say when. Two questions that rarely get asked are how reliable is mean reversion and how relevant is the historical average?
If you believe, like I do, that market excesses exist and are driven by investor behavior, then valuation models can be useful in discerning when the collective market mindset leans too far in one direction. That does not make them timing models. The mistake most people make is assuming the average is constant and reversion is guaranteed and imminent.
With the CAPE ratio, it’s a moving average, changing as the data set grows . It’s probably and literally weighed down by past data. And the average is not moving fast enough to account for the rapid changes in the business landscape – makeup of the stock market, a globalized economy, technology advances, and consumer tastes – over the last few decades. We’ve come a long way since railroad stocks dominated the U.S. stock market. Take technology – the accelerating pace of technology has had a dramatic effect and will make today look antiquated twenty years from now. How will that impact business and markets and the average?
As far as using mean reversion as part of a strategy, there’s this:
The nature of markets, though, is that every point of view has a counter, and it should come as no surprise that just as there are a plethora of strategies built around mean reversion, there are almost as many built on the presumption that it will not happen, at least during a specified time horizon…While it is easy to be an absolutist on this issue, the irony is that not only can both sides be right, even though their beliefs seem fundamentally opposed, but worse, both sides can be and often are wrong.
That’s from Professor Damodaran’s latest post – Mean Reversion: Gravitational Super Force or Dangerous Delusion? – which digs deeper into why. He doesn’t necessarily answer the questions, other than to offer some worthy thoughts and cautionary words. Give it a read.
- Investing Is a Fascinating Business – M. Housel
- How Should We Read Investor Letters? – New Yorker
- A Reading List that Yields a Solid Return on Investment – B. Ritholtz
- Here’s Why the Pundits Are Wrong About Warren Buffett – R. Lowenstein
- Would a 30 Year Old Buffett be Studying Silicon Valley Tech Companies? – MicroCapClub
- The Traits and Processes That Lead to Better Forecasts – AAII
- Finding a Better Way to Value Companies in the Digital World – Wharton
- Mental Model: Commitment and Consistency Bias – Farnam Street
- How Researchers Discovered the Basketball ‘Hot Hand’ – NY Mag
- Principles – R. Dalio