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LONG-TERM MEAN REVERSION: SHORT HOUSING, LONG STOCKS?

25 October 2009 by TPC 5 Comments

If you’re a firm believer in mean reversion a long-term look at today’s chart of the day would lead to two simple conclusions:

Short Real Estate

Long Equities

What are your thoughts?

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5 Comments »

Greater Fool said:

Mean reversion should be considered on a time frame much longer than 11 years.

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# 25 October 2009 at 4:23 PM

OregonGuy said:

One approach to equities…

Shiller’s data provides a long-term pseudo-S&P data set.
A trend line through 1948-2008 earnings results in $64 expected earnings for 2009. Apply a P/E of 18 to get an expected (mean) value of $1,153 on the S$P in 2009.

As-reported earnings aren’t expected to reach $64 until 2010 according to analysts, so current P/E is way over 18. My conclusion: we’re over-paying for earnings as we have for the last 10 years. The market has already reverted to mean valuation, but current earnings don’t support that valuation.

The chart starts in 1998 when the market was even more over-valued on a mean value basis. Comparing 1998 to now is therefore misleading by this interpretation.

That said, the market could keep going up for years and exceed trend valuation as it did 1995-2000. Who knows what the herd will do. For now, what choice does the herd have thanks to Mr. Bernancke?

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# 25 October 2009 at 4:31 PM

Rob said:

Nominal GDP is up about 63% since 1998 from $8.8 trillion to $14.4 trillion so real GDP growth must be shown in the chart which doesn’t fit with the other data which appears to be in nominal dollars.

If home prices were reasonable in 1998 and wage have grown by the same amount, then home prices should be reasonable today. (Obviously they were completely irrational in 2006.) I would say that home prices relative to wages were a bit high even in 1998, so I would agree that either home prices must fall further or wages must rise. Considering the high unemployment rate and overcapacity in the economy at the moment I would bet on falling home prices over rising wages. Assuming the wage and home price information in the chart is correct, both have grown less than GDP since 1998. The average man is not fully participating in economic growth.

If you go back further and look at US and World GDP growth compared to stock prices then one could argure that stocks are more or less fairly priced somewhere from S&P 500 at 900 and 1150. Goldman Sachs DDM model (previously posted on this site) and the Shiller P/E10 data also imply that stocks are more or less fairly valued around 1,000.

I would say mean reversion has already happened with breakneck speed. Home prices fell much quicker than anyone anticipated. Stock prices fell and recovered much quicker as well. I would say one could be comfortably long both stocks and housing provided one is satisfied with average historical foward returns in the medium to long-term.

The most striking thing on the thing on the chart is how much higher corporate profits rose in 2006, 2007, early 2008 than did the GDP, wages, or stock prices. Will profit margins just return to the mean or will they return to the 2006-2007 peak? Are exceptionally high corporate profits a good thing? Does that not signal a lack of private investment which normally is a key driver of future economic growth? Lots of golden eggs at the moment but will the goose be able to deliver forever at the same rate?