Mean Reversion: Gravitational Super Force or Dangerous Delusion?
aswathdamodaran.substack.com
In my last post on the danger of using single market metrics to time markets, I made the case that though the Shiller CAPE was high, relative to history, it was not a sufficient condition to conclude that US equities were over valued. In the comments that followed, many disagreed. While some took issue with measurement questions, noting that I should have looked at ten-year correlations, not five and one-year numbers, others argued that this metric was never meant for market timing and that the real message was that the expected returns on stocks over the next decade are likely to be low. I was surprised at how few brought up what I think is the central question, which is the assumption that the CAPE or any other market metric will move back to historic norms. This unstated belief that things revert back to the way they used to be is both deeply set, and at the heart of much of value investing, especially of the contrarian stripe. Thus, when you buy low PE stocks and or sell a stock because it has a high PE, you are implicitly assuming that the PE ratios for both will converge on an industry or market average. I am just as prone to this practice as anyone else, when I do intrinsic valuation, when I assume that operating margins and costs of capital for companies tend to converge on industry norms. That said, I continue to worry about how many of my valuation mistakes occur because I don’t question my assumptions about mean reversion enough. So, you should view this post as an attempt to be honest with myself, though I will use CAPE data as an illustrative example of both the allure and the dangers of assuming mean reversion.
Mean Reversion: Gravitational Super Force or Dangerous Delusion?
Mean Reversion: Gravitational Super Force or…
Mean Reversion: Gravitational Super Force or Dangerous Delusion?
In my last post on the danger of using single market metrics to time markets, I made the case that though the Shiller CAPE was high, relative to history, it was not a sufficient condition to conclude that US equities were over valued. In the comments that followed, many disagreed. While some took issue with measurement questions, noting that I should have looked at ten-year correlations, not five and one-year numbers, others argued that this metric was never meant for market timing and that the real message was that the expected returns on stocks over the next decade are likely to be low. I was surprised at how few brought up what I think is the central question, which is the assumption that the CAPE or any other market metric will move back to historic norms. This unstated belief that things revert back to the way they used to be is both deeply set, and at the heart of much of value investing, especially of the contrarian stripe. Thus, when you buy low PE stocks and or sell a stock because it has a high PE, you are implicitly assuming that the PE ratios for both will converge on an industry or market average. I am just as prone to this practice as anyone else, when I do intrinsic valuation, when I assume that operating margins and costs of capital for companies tend to converge on industry norms. That said, I continue to worry about how many of my valuation mistakes occur because I don’t question my assumptions about mean reversion enough. So, you should view this post as an attempt to be honest with myself, though I will use CAPE data as an illustrative example of both the allure and the dangers of assuming mean reversion.