In this issue, we aim to develop a compass… to help us figure out where we are and where we are going.
On Planet Earth, we can find our direction by reference to the Magnetic North. For investing, we use the most reliable force in finance – the relentless return to “normal” – to get our bearings.
And searching for normal, we may have stumbled upon what could be the Trade of the Century. More on that later…
Reversion to the Mean
As economists describe it, reversion to the mean is merely a recognition of the tendency for things to stay in a range that we recognize as “normal.”
Trees do not grow 1,000 feet high. People don’t run 100 mph. You don’t get something for nothing.
Normal exists because things tend to follow certain familiar patterns, shapes, and routines.
When people go out in the morning, they know, generally, whether to wear a winter coat or a pair of shorts. The temperature is not 100 degrees one day and zero the next.
Occasionally, of course, odd things happen. And sometimes, things change in a fundamental way. But usually, when people say “this time is different”… it’s time to bet on normal.
This phenomenon – reversion to the mean – has been thoroughly tested and studied in the investment world. It seems to apply to just about everything – stocks, bonds, strategies, markets, sectors… you name it.
But let’s push on. What is unusual in the chart below? What is so abnormal that the mean is likely to revert against it?
You will note that global debt was only $30 trillion in 1994. Now it is $230 trillion. That $200 trillion in extra credit is probably the whirlwind that sent equities spinning up to the top right.
Those gusts blew stock and other asset prices up to heights never seen before. The Dow reached over 26,000. Houses went on the market for more than $100 million. Gold rose above $1,900.
But while stocks and bonds may have the wind at their backs, it seems to blow in the economy’s face… making forward progress almost impossible. The real economy – as depicted by GDP at the bottom of the chart – has grown in a rather normal way, but at a slower and slower rate.
Its steady, plodding increase gives no hint of the chaos going on above it. The real economy and the financial world are as different as the eye of a hurricane and the swirling clouds and storms around it.
Another thing you notice is that until the mid-’90s… and again between 2008 and 2012… the average investor got essentially no benefit in exchange for the added risk of putting his money into equities (the chart above includes dividends). He might just as well have left his money in U.S. Treasury bonds.
In theory, he is supposed to be able to earn some return – over pure cash – by lending his money to the U.S. government (with the 10-year Treasury bond as the benchmark). He should be able to earn even more, a premium (more than he would earn from risk-free Treasurys), by investing in stocks. The premium is supposed to compensate him for the risk that his stocks could go down at an inconvenient time.
In practice, we find that risk-free Treasurys gave him less than nothing. He has earned less from Treasurys than he would have from gold (which pays zero interest) – over the entire 48-year period.
Stocks, meanwhile, earned him nothing for the first 24 years. Then they exploded to the upside, along with debt, until the financial crisis brought them back in line with gold.
By 2008, the average investor was again earning less on stocks – despite all the risk and bother of market investing – than on gold. It continued like that until 2012, when his stock investments shot up.
But there is a time to be in stocks… and a time to be out of them. Without knowing the future, you can still know when something is not normal. And when something is not normal… it is just biding its time until it becomes normal again.