Market Too Expensive? – Reversion to the Mean at work.

(As the Dow Jones Industrial Average hits new highs, there are many claiming it to be “over-valued”, “ready for a correction”, or “expensive”.  Most of these explanations share the same basic premise – reversion to the mean.

Reversion-to-the-mean (RTTM) simply implies that there is some “true” or “appropriate” level for valuations in the stock market.  Most of these values are derived from historical analysis.  Pundits compare today’s values to some sort of average (or mean) .  They then conclude that the market will be headed back towards its historical value in the future – hence the use of the term reversion.  So, the concept is that the market is off its long-term average value, and will be drawn back to this value over time.

Two big problems with these arguments.

1.  What is the “force” that drives the market back?  The RTTM concept works well in physical sciences where all behavior of particles is driven by the four fundamental laws of physics.  What fundamental law is at work here?  It’s just us humans using our minds. (Kind of scary I know.  What limits human creativity?)

2. The whole argument rests on the notion that we know what the “correct” or “appropriate” level is.  In statistics, they use sampling techniques to estimate what the “mean’ value is for a given population.  Works well if the population being studied is normal, follows fundamental physical laws, and the size of your sample relative to the size of the overall population is known.

But what do we know about the history of capitalism?  Will it continue for another 100 years? 500?  What makes us think what we have seen in the past is indicative or typical?  Maybe it was just an abnormal episode?  Do we want to look at the “mean” of an abnormal episode?

The best example of how these arguments can lead us astray was our last “great recession”.  We had only seen a national home price decline of large magnitude during the great depression of the 1930s.  We assigned AAA values to securities because we thought we knew the range of possible outcomes by looking back at history.  We were not ready for the national home price decline we ended up experiencing which was worse than implied by looking at the stats.  Oops.

All this to say that you need to know what you do not know.  We really do not know the ‘correct” or “appropriate” values for the stock market.  History can serve as a guide at times, but it does have fundamental flaws that will never be solved.  Be wary of the RTTM arguments that pop up every time we are above some long-term average – it really does not tell you much about where we are headed next.