Profits Always Mean Revert

Here’s an interesting tidbit from the mean reversion school of investing.  Like most things in financial markets, mean reversion is a pretty standard occurrence.  Market prices mean revert, valuations mean revert, profit growth mean reverts, you get the picture.  Of course, the problem with mean reversion is not knowing whether it will happen, but know WHEN it will happen.

That said, I found this chart and commentary pretty interesting (via Meb Faber):

 “At the peak of the cycle, when profits are far above average and the economy is doing well, it is hard to imagine earnings collapsing back below the average, as it is to imagine a depressed region recovering. Mean-reversion in earnings, though sometimes delayed, is as undeniable as the economic cycle itself. Cyclically adjusted (or trend) PE calculations will always give a conservative valuation estimate. But that is exactly the point of valuation – to offer a degree of safety (a margin of error) and to smooth the dangers of the economic cycle. That peak profits typically accompany peak valuations only reinforces the point.

One can always discuss the idiosyncrasies of any particular valuation metric, although we reach similar conclusions to Robert Shiller’s CAPE analysis – but using a more modern time frame and a different (and more generous) earnings series. Our conclusions are that the US equity market is currently expensive. We can also reach a similar conclusion using alternative valuation metrics such as dividend yield, trend PE, and Tobin’s Q.

Most significantly, the downside risk of investing when earnings and valuations are far above historical averages should not be underestimated.  from our work, peak earnings go hand-inhand with peak valuations. When earnings revert back to mean (and below), the valuation will also collapse. That many continue to argue against this, and so soon after the collapse of 2008/09, is something we find quite remarkable.”

 

Source: SocGen