Stock Investors Should Fear These Four Critical Words

November 1, 2017, 5:35 PM UTC

The stock market has shown extraordinary momentum since the presidential election, and investors who placed bets on that irresistible force have garnered big gains. But folks should think hard about another force that’s a lot more reliable than momentum. According to history, it’s the real irresistible force, and it consists of four words: Reversion to the Mean.

The portfolio managers and equity strategists at America’s big banks are selling equities hard. Despite what look like super-rich valuations, they keep parading familiar bullet points to assert that stocks are still a bargain. They note that profits are growing fast and that sweeping tax reform could send them soaring to fresh heights, that President Trump’s pick for Federal Reserve chairman is likely to hold interest rates low, and that a new wave of deregulation is unshackling pent-up capital investing and unleashing animal spirits in corporate c-suites.

But when you consider reversion to the mean, Wall Street’s slant on the stock market seems as exaggerated as a funhouse mirror that elongates a scrawny kid to the height of an NBA center.

To best understand reversion, think of the S&P 500 as one big share of stock. The concept states that when the price of that share becomes extremely elevated compared with the earnings investors gain from that share, either in the form of dividends or reinvested earnings, the price relative to those earnings returns to the long-term average, as if governed by a gravitational force.

So let’s examine what happens to that ratio of price to earnings, or the market PE, after it rises to unusually high levels—precisely the scenario investors face today.

The best measure for current stock valuations is the CAPE, or cyclically adjusted price-to-earnings ratio, developed by Yale economist Robert Shiller. The CAPE smooths out volatile fluctuations in earnings by using a 10-year average of inflation-adjusted profits as the current reading. The reason is basic: When earnings spike, non-adjusted PEs look artificially low—the likely picture today—and when they dive as in 2009, equities look falsely expensive. The CAPE removes those distortions.

The CAPE for the S&P 500 averaged around 16 from 1888 to 1990, and a much higher 19 over the last quarter century. A graph of the CAPE since the late 1960s displays four periods when the measure rose to extremes. And it’s instructive to see what happened after the measure soared far above those benchmarks.

The first plateau: From July 1962 to November 1965, the CAPE rose sharply, from 17 to 24. By late 1970, it had fallen to its long-term average of 16. The second example: In early 1992, the CAPE stood at around 19, once again, near its normal level in recent decades. By July 1999, it had jumped to its highest point ever, 44. Then the customary fear of heights prevailed, and by February 2003, the CAPE had dropped by half to 21.

Stock investors watching stock prices fall during a market crash.
Traders at the New York Stock Exchange watching as prices fall on February 25, 2000–not long after a spike in the CAPE ratio.Chris Hondros — Getty Images
Chris Hondros — Getty Images

The third case: After the big fall from mid-1999 to early 2003, the CAPE rebounded to almost 28 in May 2007. Once again, gravity took hold, and it slipped to 20 in late 2010 as America emerged from the financial crisis. The fourth example applies today: Since late 2010, the CAPE has done a hockey stick, hitting a sixteen-year record of 31.2 in October.

The review of past spikes makes a basic point: The CAPE has never, ever stayed at 31 for a sustained period. It’s only exceeded that level twice, first briefly prior to the historic crash of 1929, and second, during a relatively long, four-year stretch during the tech bubble from mid-1997 to mid-2001. And as goes almost without saying, each past spike was followed by a wealth-zapping crash.

Here’s the danger: If the S&P 500 were to revert to a CAPE of 20, just above its average in recent decades, stock prices would need to fall by 36%. This isn’t a prediction that such a collapse is imminent, or will happen at all. It’s simply a reminder that while momentum is on the market’s side, history is not.

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