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Thursday, August 5, 2010

The Power of Mean Reversion

Index Universe (hat tip Abnormnal Returns) details why now may be the time to allocate to U.S. equities... reversion to the mean.

There have only been four decade-long periods where U.S. equities have delivered negative returns, which were the 10 years ending in 1937, 1938, 1939 and 2008 (2009 was not included in the study). In each case, the subsequent 10-year period was strongly positive, with equities delivering (on average) an 11 percent compound annual return. Reversion to the mean. It’s simple, but it works.
Rather than look at nominal returns, I took at look at rolling ten year total returns of the S&P 500 index in real terms and then took a look at what the relationship was to ten year forward total real returns (using year end levels).

While the past is not a perfect predictor of the future, there has not been one period in which the ten year real return of the S&P 500 was negative, then followed by another decade of negative ten year real returns going back to data from the 1880's (i.e. no marker in the bottom left quadrant).

Source: Irrational Exuberance