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By Jason Stipp and John Rekenthaler | 09-04-2013 12:00 PM

What Meaning From Mean Reversion?

Mean reversion is a compelling concept in hindsight, but not as straightforward as a stand-alone signal in the here and now, says Morningstar's John Rekenthaler.

Jason Stipp: I’m Jason Stipp for Morningstar. Reversion to mean is a powerfully compelling concept, especially as some long-term metrics, such as the Shiller P/E, look to be above long-term averages, but there's more to reversion to the mean than it appears. Here to talk about that is John Rekenthaler. He is vice president of research for Morningstar and Morningstar.com columnist.

Thanks for joining me, John.

John Rekenthaler: Yes, Jason, glad to be here.

Stipp: The idea of reversion to mean is talked about a lot by a lot of investing greats, including [GMO's Jeremy] Grantham and many others, and folks are looking at certain long-term metrics such as Shiller P/E, which looks elevated right now and they're saying that we're probably in for a stock market correction because this powerful concept we’ve seen throughout history. You say reversion to the mean is compelling, but it's also susceptible to some biases. Can you explain that?

Rekenthaler: Yes, I can. Let me step back for a second because you talked about the Shiller P/E ratio, and there is an ongoing discussion that it’s happening right now between Shiller and Jeremy Siegel of [the Wharton School], who often find themselves on the opposite end of a debate because Jeremy tends to be relatively bullish on stocks. He is the author of Stocks for the Long Run, after all, 20 years ago, and the Shiller ratio for the last 20 years, which looks at sort of cyclically adjusted or 10-year average price/earnings ratios, for the last 20 years has given off a relatively bearish signal.

The discussion of mean reversion is a little bit broader than that. That's a debate that’s going on right now, and you can pick up The Financial Times this week and The Wall Street Journal last month and see Shiller versus Siegel: Who is right? But I want to step back and just think a little bit more broadly about the issue of mean reversion because what's the point of using these ratios, such as the Shiller ratio? There is a notion of mean reversion, when you get above some sort of trend line with the ratio, that's supposed to indicate that the market is too expensive, and when you get below, that indicates that it’s cheaper and maybe you should buy.

I read an interesting paper recently by three London Business School professors. They tried to look at this concept of mean reversion more broadly. The basic point of the argument is, it looks very convincing when you go backwards and you fit a line to the data that you have. You have a full set of data and you look and say, "Well, in 1992, with this set of data that goes past 1992, here's what I would have done." It doesn't seem to work so well in practice.

It looks crystal clear right now; it looks crystal clear going backward. It doesn't seem to work so well in 1992 when you didn’t have the benefit of the next 21 years’ worth of data to help you create that mean line or that trend line. It's a pretty thorough work. The professors look at 20 different stock markets going back as far as they can, and the U.S. has the longest track records--113 years, a long time. But the other markets are multiple decades. The [professors] found it’s very difficult to implement mean-reversion strategies in practice, that they're not able in general to find statistically significant results in improvement of portfolios--basically better returns on portfolios--by moving from stocks to cash or cash back to stocks based on market valuations.

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