March 8, 2008

Historical PE: revision to the mean

The revision to the mean is a concept where all asset prices must revert to their historical average returns. In today's market the inflation adjusted inflation adjusted Price Earnings ratio PE stands at 25 while its long term average is 17. The real PE has came down quite a lot from its peak in 2000, but to hold the revision to the mean concept it must come back even more.
You can see the chart that whenever the real PE peaked, a correction followed to restore historical averages. In every bull market with no exception, 1900s, 60's, 80-90's, PE has came back down to restore the average.
An excerpt of FairFax Financial shareholders letter touches on the issue:

Hyman Minsky, the father of the Financial Instability Hypothesis, said that
history shows that “stability causes instability”. Prolonged periods of
prosperity lead to leveraged financial structures that cause instability. We are
witnessing the aftereffects of the longest economic recovery (more than 20
years) in the U.S. with the shortest recession (2001). Regression to the mean
has begun – but only just begun!

Recently, we came across an interesting observation by the man who provided the intellectual underpinnings of “long term value investing” and to whom we are ever indebted. BenGraham made the point that only 1 in 100 of the investors who were invested in the stockmarket in 1925 survived the crash of 1929 – 1932. If you didn’t see the risks in 1925 (very hard to do), it was very unlikely that you survived the crash! We think Ben’s observation may be relevant to what we have experienced in the past five years. We reminded you in our 2005 Annual Report that “Jeremy Grantham of Grantham Mayo said that of the 28 bubbles that they have studied in all asset categories (including gold, silver, Japanese equities and 1929), this recent bubble in the U.S. stock market is the only one that has not completely reversed itself (just as it was about to in 2003, it turned and rebounded).” Caveat emptor!!

In our 2005 Annual Report, we also discussed the Japanese experience from 1989 to 2004 when the Nikkei Dow dropped from 39,000 to 7,600 while yields on 10 year Japanese government bonds collapsed from 8.2% to 0.5%. With the Federal Reserve dropping the Fed Funds rate down to 3% from 5.25%, we might be witnessing a repeat in the U.S. of the Japanese experience. In spite of record low interest rates and record high fiscal deficits, Japan went through years of mild deflation. The feelings at the time in Japan were that they were different and would not allow stock prices and land prices to fall – not dissimilar to the sentiment currently prevailing in the U.S.!!

A review of real PE suggests three possible scenarios for market direction:

  1. Market prices will be be flat for the next decade while real earnings need to grow by a compounded 4.4% annually, or

  2. A swift correction of prices of 30% to align to the historic averages , or

  3. some combination of both, which is the most likely scenario.

The implication of the above for investors is that value and stock picking skills are needed for the next chapter of the market. In the 1980'2 and 1990's those skills need not apply if you have simply held an index you did fine. That's why most index funds and ETFs proliferated in the last decade. Going forward I do not think it is a wise choice, if you need your money within 5 years. However if you have longer time horizon then index averaging is good strategy. That's why I am intending to reduce my index fund weighting to 30% of my portfolio and concentrate on selecting individual positions that meets my criteria of value.

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