Statisticians who watch the stock market are accustomed to using the phrase “mean reversion” to describe how returns from investing in equities tend to come back to their long-term averages after they diverge for awhile.
The extraordinary period that ended about a year ago, which saw the NASDAQ Index climb past 5,000, clearly represented an enormous divergence, and the painful year since has certainly been one of mean reversion.
Jeremy Siegel of the Wharton Business School has shown that there never was and never can be a justification for average PEs on tech stocks that are almost 70 times the previous year’s earnings, as they were in March 2000. Sure, individual companies can merit such multiples or, indeed, an infinite PE in certain cases, but the average during the 1990s, according to Siegel, has been for stocks to trade at around 20 times earnings, and the sustainable figure is now in the low-to-mid 20s.
If Siegel is correct, then the questions of interest to us today are
*Have stocks overall corrected enough, or too far? *Do technology stocks deserve any type of premium to the market? *What are the implications for bonds & interest rates?
The answer to the first question is a resounding “maybe”. The Price/Earnings ratio based on historic profits is currently around 24. The real issue is what will next year’s earnings be for the nation’s largest companies? Though we have seen significant changes in the outlook for many companies, most of them technology firms, expectations are still for the sum of all earnings to grow modestly.
Tech stocks may be a different matter. Siegel maintains that, over the long haul, no tech stock has delivered exceptional returns, and he’s made the point that an index fund would have beaten IBM over the past 40 years, and IBM can claim to be the “best” tech stock over the same period.
The trouble with tech stocks is that, in the parlance of the Street, they have no “visibility”. Not even analysts who closely follow them can guess at their profits over the next year. Historic PEs, therefore, are totally meaningless. If they weren’t, most good technology stocks would be resounding “buys”.
Our belief is that, as quickly as the order books for technology companies have evaporated, they can return, and a rapid earnings recovery cannot be ruled out either. In short, it may be a mistake for growth investors to turn completely away from the “techs”.
Concerning the effect of mean reversion in the stock market on interest rates and bonds, clearly some of the “refugee money” from the slaughtered tech sector has fled into short-term government securities, thus depressing yields in the sector and causing a more normal yield curve. Long-term bond yields have come down somewhat, but nowhere near as much as the yield on shorter-term securities. The surge in the value of ten-year Treasury securities has been extraordinary since early November, with yields falling from over 6% to a little over 4%. This has been a historic move, just as extreme as the surge in NASDAQ stocks over a year ago.
Which leads us, therefore, to an interesting speculation: is it time for mean reversion in the market for Notes and Bills? Yes – and big time – but not until after the next rate cut by the Fed.
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The views expressed within represent those of the author, and do not necessarily reflect those of Capitalism Magazine’s publishers.
