Newton, mean reversion and the market

By Neel Kashkari of PIMCO.

These Newtonian beliefs also affect how many people think about investing. “Mean reversion” is the investment world’s version of “what goes up must come down.” It’s usually a pretty good rule. Mean reversion suggested that the extraordinary price to earnings multiples of technology stocks in the late 1990s couldn’t last; they would eventually revert to historical average valuations. Similarly, mean reversion suggested that house price increases in the U.S. in the mid-2000s weren’t sustainable. They didn’t last either.

But is mean reversion always right? In 2000 mean reversion would have suggested the bull market for bonds would be over. Interest rates couldn’t stay low, let alone fall further, could they? But here we are in 2012 and we’re not predicting a bear market any time soon.

In tension with mean reversion is Newton’s First Law: A body at rest tends to stay at rest. In investment parlance there needs to be a catalyst to force the system to revert to the mean. Left alone, it may continue in its elevated state for a long time.

The timing of that reversion matters: Just because someone can identify a bubble doesn’t mean they can make money from their insight. People who shorted tech stocks too early may have lost a lot of money while the bubble kept expanding.

Today many equity investors are asking whether corporate profit margins can stay strong. Coming out of the financial crisis, many large corporations, especially multinationals, have enjoyed record profits. This is counterintuitive given the low growth much of the developed world has experienced during this time. Corporations responded to the financial crisis by paying down debt and cutting costs, positioning them for strong profit growth as their end markets slowly recovered. Figure 1 is a chart of corporate profit margins, earnings multiples and the overall level of the S&P 500.

Global equity markets have climbed 6.5% year to date (source: MSCI World Index through 11 April 2012). With record profits, earnings multiples still seem reasonable at 14.5 times. Stock prices today are anchored on strong profits, hence investors’ intense focus on the sustainability of those profits. If they fall, stock prices are likely to follow. To assess the vulnerability of profit margins, let’s review several possible catalysts for profit mean reversion and consider how likely they are to occur:

Full article here.