The Trouble with Mean Reversion

Mean reversion is a key part of many investors’ strategies, and right now some are pointing to above-the-mean cyclically-adjusted price/earnings ratios as a sign that stocks are overvalued. But Morningstar Vice President of Research John Rekenthaler says mean reversion isn’t as simple as it may seem. If you take the current long-term mean and see where stocks were in relation to that mean in, say, 1992, it might look like it was an easy choice to buy or sell stocks back then, Rekenthaler notes. “It looks crystal clear going backwards,” he says. “[But it doesn’t seem to work so well in 1992, when you didn’t have the benefit of the next 21 years worth of data to help you create that mean line.” In other words, the long-term mean you are seeing at any given time can change significantly in coming years as more and more data rolls in, making it challenging to tell in the moment where things stand. Rekenthaler says that when valuations stray to real extremes from a mean, that can still be a useful factor in investing. But other factors should be considered as well, he says — like the attractiveness of other assets — and right now he doesn’t think valuations are at a point where warning signs are flashing.

Screen shot 2013-09-04 at 5.10.44 PM