Mean reversion or equity revulsion?
Writing in the FT’s weekly investment industry FT supplement, FTfm (Monday 4th March), Edward Chancellor of Boston-based global equity managers GMO tells us ‘in today’s uncertain world, investors should not lightly relinquish their faith in mean reversion’. He is talking about the investment returns earned by the entire equity market of a country, not individual stocks. He adds: ‘The fact that we observe mean reversion in the data is not merely some statistical artefact. Rather it is grounded in economic theory.’ He relates the mean-reverting real returns that investors have earned from equity markets (as measured by representative indices over long periods) to mean-reverting returns in business, flowing from the powerful competition in liberal, open markets in both ideas and capital.
It is a mark of the modishness of ‘equity revulsion’ that we need to be encouraged to hold on to a belief about the equity return process so fundamental that it is difficult to imagine anyone rational ever holding equities without that belief as bedrock.
We certainly designed our investment approach on the presumption of mean reversion in real equity returns, after inflation. It is the basis of our modelling of market real returns and, when combined with risk-management disciplines, of real outcomes at future horizons (as capital or cash flows) of goal-based portfolios. So we have a lot at stake on this definition of the return process. Like Mr Chancellor, we believe that this is the one constant in an ever-changing world. Like Mr Chancellor, we think it has a theoretical justification rather than being a statistical fluke.
We also think that an enormous amount can be done – in both financial planning and portfolio management – building on this one belief, even when agnostic about much else in investing. When clients choose a manager or adviser they necessarily take on the risk of error in that firm’s own belief system, even if they do not realise it. So if clients have to hang their hat on something, why would it not be this fundamental characteristic of the capitalist system?
So why has the world started to question this presumption, opting instead for cash, bonds and ‘new’ sources of alternative asset returns? Why the equity revulsion so aptly captured in talk of ‘the end of the cult of the equity’ (eg FT November 2012 or PIMCO July 2012)?
Revulsion is the product of investor emotion but also of new reasoning about the inappropriateness of equity risk for many institutional investors that have liabilities. It does not only owe its origins to the exceptional scale of the economic problems in the wake of the credit crunch, although this has clearly caused many investors, institutional and individual, to lower their tolerance of equity risk. It is changes in the average-investor risk tolerance that probably best explain the cycle of bounded deviations from the long-term trend of equity real returns (a Nobel prize awaits the proof).
Even before the crisis, a new mindset for accounting for liabilities, applicable to many institutional investors, had tended to replace trust in the equity return process with agnosticism about future returns. When accounting dominates economics, it makes little difference whether you believe returns are mean reverting or purely random: equities are simply too uncertain to hold as reserves against future liabilities. No matter, apparently, that without business, or without equity, there is nothing to underpin the promises of so-called low-risk assets, including government bonds.
It is therefore striking, but to us not at all surprising, that actual returns in the bear market and subsequent recovery are in fact entirely consistent with past cycles. Maybe institutional behaviour explains more of the change in average risk tolerance than sentiment does on this occasion, but the change in tolerance itself is well within the bounds of past deviations.
All the major markets bottomed in 2009 at levels equivalent to between 40% (Japan) and 70% (UK) of their trend of achieved real returns for representative indices, using data going back between 60 and 120 years. Japan’s most extreme deviation is almost exactly equal to the UK’s in 1974 (based on the trend up to that point). All but Japan (50%) have already reverted to within 20% of their trend.
We do not think it matters much what the differences are in each cycle. They can help explain what has happened but give no insight into what will happen. It is foolish to assume that ‘this time it is different’: better to assume that there are always enough marginal investors with more constant risk tolerance to prevent markets falling interminably and even to prevent the measured trends themselves from shifting permanently lower. Like Pascal’s wager, back the system: if you are wrong, there is no safe haven for capital anyway.