John Hussman of the Hussman Funds presents at the 2014 Wine Country Conference
www.winecountryconference.com to see videos, get updates about next year's conference, and to help support the Autism Society of America.
John Hussman of the Hussman Funds presents at the 2014 Wine Country Conference
www.winecountryconference.com to see videos, get updates about next year's conference, and to help support the Autism Society of America.
John Hussman of the Hussman Funds presents at the 2014 Wine Country Conference
www.winecountryconference.com to see videos, get updates about next year's conference, and to help support the Autism Society of America.
Wine Country Conference, 2014 to benefit the Autism Society of America
You are here. Identifying mean reversion Identifying mean reversion Identifying mean reversion Notice that subsequent change is inverse to the present level.
Identifying mean reversion Standard mean-reverting process X future = X today * (M/X today )^{1 e -aT }
Where a is the adjustment speed, M is the mean, and T is the time to future
The future % change in X will be proportional to log(M/X today ) When X is well above the mean M, future change will be negative When X is well below the mean M, future change in X will be positive
If we have some Fundamental F that is representative of the mean M, then the future % change in X will be inversely related to the present log(X/F) This result holds even if M and F grow over time.
We test mean reversion in X not by examining X itself but by relating X to some representative fundamental F then checking whether future changes in X are inverse to the present X/F
* Geeks Note: Technically, we expect future % changes in X to be inverse to the current level of log(X/F)
Hate math? Just remember this Mean reversion is hard to detect directly The level of X isnt enough to tell the story The real tipoff: Future market returns are inverse to present log(price/fundamental) Why an equity bubble isnt obvious Profit margins are 70% above their historical norm, for reasons that have a great deal to do with the present economic cycle, but should not be expected to persist.
Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean- revert, then something has gone badly wrong with capitalism. - Jeremy Grantham Why should we care? We do not care about profit margins out of concern that earnings will decline over the next few years and stocks will fall as a result. While both may happen, the fact is that market changes usually have little correlation with short- run changes in corporate profits. We care about profit margins because stocks are a roughly 50-year duration claim on future cash flows. By thinking that stock prices can be valued as a simple multiple of todays earnings, investors are using todays earnings as if they are representative of that entire long term stream for decades, and decades, and decades to come. Does profitability mean-revert? The test of mean-reversion is whether subsequent changes run inverse to present levels. So far, they do.
Does profitability mean-revert? Not everyone likes my use of CPATAX. Other variants dont change the basic story.
Corporate profits are a mirror-image of deficits in other sectors We know why margins have been elevated. Nothing in this dynamic has changed.
Until recently, slow real wage growth has supported profit growth. We know why margins have been elevated. Nothing in this dynamic has changed.
The Iron Law of Valuation Every security is a claim on some expected stream of future cash flows that will be delivered to the investor over time.
The higher the price an investor pays for that stream of cash flows, the lower the expected return.
The lower the price an investor pays for that stream of cash flows, the higher the expected return.
A reliable valuation fundamental F acts as a sufficient statistic that maintains proportionality to those long-run cash flows. So the higher the ratio of Price/F, the lower the long-term expected return, and vice versa. Current earnings can be terribly unrepresentative as sufficient statistics for long-run cash flows
Observation over many years has taught us that the chief losses to investors come from the purchase of low- quality securities at times of good business conditions. The purchasers view the good current earnings as equivalent to earning power and assume that prosperity is equivalent to safety.
- Benjamin Graham Margins and multiples matter jointly Margins and multiples matter jointly Margins and multiples matter jointly Expected 2-year total returns Valuations do not reliably mean-revert at short horizons. Error bands are very wide.
Expected 3-year total returns Significant errors even at 3-year horizon
Expected 5-year total returns Range and frequency of errors improving at about 5 years, but still large.
Expected 7-year total returns Range of error narrowing. Zero expected return at this horizon.
Expected 10-year total returns Prospective 10-year total returns about 2.4% annually
Expected 15-year total returns Prospective 15-year total returns still only 4.4% annually Expected 20-year total returns Prospective 20-year returns only about 5.5% annually here. Note slightly off phase profile. Prospective returns are negative at horizons of less than 7 years Reliable valuation measures are double historical norms Reliable valuation measures imply weak future returns Its not different this time. Reversion to the mean is the iron rule of the financial markets
John Bogle
Many shall be restored that are now fallen; and many shall fall that are now in honour.
Horace Ars Poetica as quoted in Security Analysis by Benjamin Graham and David Dodd
I got wiped out personally in 1968, which was the last really crazy, silly stock market before the Internet era I became a great reader of history books. I was shocked and horrified to discover that I had just learned a lesson that was freely available all the way back to the South Sea Bubble.
Jeremy Grantham
Addenda: Shiller P/E Adjusting for profit margins embedded in Shiller earnings (which matter!) the Shiller P/E would presently be above 30. Median and mean price/revenue A hideous opportunity set James Montier Consequences of yield-seeking