Mean Reversion
What is it and why does it matter?
Regression to the mean is a statistical law where an unusually high or low measurement is likely to be followed by a measurement closer to the average (or geometric mean). Anyone remember this from Stats class?
Financial (stock) markets call this mean reversion. The financial markets apply this stats law as a trading theory that asset (stock) prices eventually revert to their long-term mean or average level. Basically, what goes up must come back down.
Standard Deviation
Within a statistical regression model, standard deviation (SD) measures the typical distance between observed data points and the (predicted) regression line, indicating model accuracy.
Stock Market Valuation
Moving from stats into stock markets, there are many recognized ways to place value on an individual company in the market. And by extension, the entire stock market can also be valued.
Methods of valuation include a comparison of company stock price to its earnings (P/E ratio), a cyclically adjusted company stock price to earnings (Cyclical P/E or CAPE ratio), company value to replacement cost of assets (Q ratio), and a simple look at a company’s stock price.
Keep in mind that company (and market) valuations are estimated true worth of a company (the entire market) while price is simply what an investor pays for a share at any given moment.
The Graph
The busy graph provided as this blog’s image, complements of Venable Park (1), includes an average of four different stock market valuations covering a large data set, a period of 125 years. The X axis is in %, with the geometric mean identified as 0%. The horizontal lines represent standard deviations (SD) above and below the geometric mean. The vertical grey areas represent historical periods of recession. The pink areas represent the most recent valuation decline and speculation on the next decline. The blue arrows and comments are added by Venable Park.
What Does the Graph Tell Us?
About the Stock Market
· Four different valuation methods agree stock valuations are at all-time highs
· Mean reversion of stock valuations is increasingly likely
About the Last 50ish Years (2)
· Recessions have been much less common in my adult life
· Higher highs and higher lows are occurring. The mean will move up over time
These are all facts any financial advisor can look up and discuss with you. If they are primarily discussing the big gains from recent years and not looking at the coming year(s) mean reversion risk, I’d suggest you Be Prepared for what’s coming sooner than later and lead them into a risk discussion.
1. Venable Park Investment Council Inc,, a Canadian financial advisory firm
2. PS. The why for these last 50 years can be found in blogs including Fiat 25Oct24 and Debasement 21Oct25