Share this Post on Twitter

Tuesday, November 17, 2015

The Mean Reversion Case For (and Against) Strong Future Returns

Bull thesis: 15-year S&P annualized returns ending 9/30/15 came in at just under 4%. The average forward return since 1915 when returns were that level (or lower) was 15.5% annualized over the next 15 years with a standard deviation of only 2%

Bear thesis: the 15-year starting point came when the previous 15 year annualized returns were just under 18% (i.e. we are still working off extreme valuations)

The counter argument to the bear argument can be seen in the chart below which compares the same 15 year historical returns on the x-axis with 30 year forward returns on the y-axis. As outlined in my previous post, returns tend to smooth out over 30 years, thus it matters a lot less what you pay for stocks over 30 years than over 5, 10, or even 15 years because more of the return is composed of fundamentals (i.e. dividends, buybacks, etc...) than multiple expansion / contraction as compared to shorter periods. Thus even extreme valuations have historically delivered 30 year returns I think most investors would find acceptable at the moment.

My take? Right between the two. I am not nearly as scared by current valuations, peak margins, etc.. as bears (especially over longer time frames) and I am not remotely a bull either. That said, I'm also not worried about a short term correction that would likely create a much better buying opportunity in the future.