Friday, July 3, 2009

The Mean Reversion Fallacy - Ari Paul

Just about every analysis of the economy and stock market looks to the last 90 years to predict the future. We look at the US markets from 1920 mostly because we just don’t have good data from earlier times. Benjamin Graham, the father of value investing, based much of his analysis on the observation that the US market since 1920 had meandered from highs to lows with a general upward trend. Warren Buffett employed the same kind of empirical mean reversion strategy, famously saying, “It’s never paid to bet against America.” The same observations and predictions could have been successfully employed in the Netherlands, France, England, and even the Holy Roman Empire at different times. Mean reversion works until it doesn’t. Will the next 90 years of US stock returns look the same as the previous 90?

The assumption that equities will moderately outpace inflation over time is primarily empirical but also contains direct logical inferences that I'll confront. We assume that the continuous investment in capital and new technological discoveries will lead to growth in productivity. At least some of this productivity growth is likely to be captured by publicly traded companies, and thus equities should do well. As general statements these are quite reasonable, but history is littered with counterexamples. One such example is the financial industry of the US over the last 40 years. It's difficult to come up with exact numbers, but it's likely that despite tremendous earnings growth, investors have actually lost after inflation by investing in financial equities. The reason is that corporate earnings were spent on inflated salaries, diluted by new issuance to insiders, and lost to fraud, rather than enriching shareholders.

Another issue is that while the history of mankind over 3000 years has been of rising productivity, it has been neither continuous nor evenly dispersed. Empires have risen and fallen. The causes of an empire's decline are outside the scope of this post, but like a highflying growth stock, deterioration is a safer bet than that dominance will continue indefinitely. Under severe inflation, a currency collapse, an overthrow of the government, a devastating war, or simply a slow deterioration, equities may produce indefinite negative real returns.

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