DAILY SKETCH - Mean-reversion as the iron law of financial markets

    • Daily sketch

Total equity return generally has three components: dividend yield, change/dynamics of corporate earnings and change/dynamics of valuations. Dividend yield is the most stable component of total equity return and at the level of major stock indices is around 2-3% per year. Change, respectively dynamics of corporate earnings has a strong tendency to make a positive contribution to total equity return in the long-term, as GDP is in the long-term growth trend. However, this trend is sometimes interrupted by recessions, as was the case last year due to the global pandemic. However, these periods usually last only a few quarters and the dynamics of GDP, respectively the dynamics of corporate earnings then return to their long-term growth trend.

DAILY SKETCH - Mean-reversion as the iron law of financial markets

Change, respectively dynamics of equity valuations is a completely different discipline. Although equity valuations tend to shoot up (greed) and down (fear) in a short period of several years, in the medium to long-term equity valuations have a strong tendency to return to the average, respectively the fundamentally justified long-term level. This process is the iron law of financial markets and is referred to as the mean-reversion process.

Given that global equity valuations are currently at all-time highs, it is very likely that in the coming years the change, respectively the dynamics of equity valuations will contribute negatively to the total equity return, because within the mean-reversion process equity valuations should begin to slowly and gradually decline and approach the historical average, respectively the equilibrium fundamentally justified levels.

Of course, no one can time financial markets exactly, so it is quite possible that valuations will still continue to grow for some time to come. After all, I am also somewhat inclined to believe that equilibrium valuations are now slightly higher than in the past, due to the record low interest rates and the still unprecedented quantitative easing of key central banks.

On the other hand, I believe that the current global equity valuations, according to my global valuation Z-Score at almost three standard deviations above long-term historical averages, shot upwards too much, to levels that even continued quantitative easing cannot justify.

However, it should also be noted that record valuations are not in themselves a negative catalyst for a major equity correction. Looking at history, the negative catalyst for large equity corrections has usually been the beginning of monetary policies tightening. And with the US Fed clearly indicating that key interest rates will not rise until at least 2024, this negative catalyst is unlikely to materialize in the coming quarters.

In any case, it is clear that record valuations for the coming years imply significantly below-average expected annual returns. Investors will have to admit this fact. I don't think this time will be different.
Michal Stupavský
Investment Strategist at Conseq Investment Management, a.s.


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