Your Money

“Reversion to the mean” is a useful concept in investing. When we apply this concept to stock index valuation, this implies that there is a tendency for stock prices to trend higher when the market PE is well below the historical mean, and a tendency for stock prices to trend lower when the market PE is well above the historical mean. Reversions to mean valuations can take place over a long or short period of time, and it can happen by stock prices adjusting or by earnings adjusting. For example, one way for an overvalued stock market to revert to a more normal valuation level is for stocks to “grow into their valuation.” In other words, earnings growth could exceed stock price growth for a period of time, bringing valuations back into line with historical norms. Another way to revert to mean valuations is for stock prices to pull back. In most cases, stocks remain at valuations above or below their historical mean PE for years at a time, and it’s never known in advance by what mechanism, or when, the reversion to the mean will occur. Nonetheless, it’s always helpful to know where we are in the valuation cycle, since persistently high stock market valuations will eventually be a headwind to future stock price gains, and persistently low stock market valuations will eventually be a tailwind.

As mentioned in a previous newsletter, the bond market in 2013 got off to its weakest 1st half start since 1994. One silver lining to point out is that bond yields have increased as a result, since bond prices and interest rates move in opposite directions. Therefore, the silver lining of the bond selloff is that interest rates for investors in bonds are a good deal higher than they were at the start of the year. At the low of 2013, a purchaser of a 10 year Treasury bond would have received an interest rate of only 1.6%. Today, a purchaser of a 10 year Treasury bond would earn interest of 2.9%. This is good news for bondholders who are being compensated better for lending their money to borrowers.