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What Goes Down

Jonathan Clements

IT MIGHT SEEM LIKE an obscure academic question: Do stocks truly follow a random walk or can we count on them reverting to the mean? Depending on which side we favor in this debate, it can make a huge difference to how we invest—and to our confidence as investors.

Like me, many HumbleDollar readers have most or all their investment dollars in index funds. A key reason we invest this way: It’s impossible to predict which stocks will shine because they follow a random walk. In other words, what happens to share prices on Monday tells us nothing about Tuesday, because Tuesday’s price movements will be driven by news that, by definition, isn’t yet known. The upshot: Our best bet is to diversify broadly and at the lowest possible cost, which is what index funds allow us to do.

But I suspect that—again like me—many HumbleDollar readers also believe that markets mean revert. If the stock market plunges this year, we feel that improves the odds that stocks will fare better next year and thus we don’t believe share price movements are completely random. Without this sort of conviction, it would be hard to ride out a major market decline. After all, if we couldn’t count on stock prices bouncing back, why shouldn’t we panic and sell?

It might seem contradictory to assume that the daily movement of individual stocks is random, while also assuming that the overall market reverts to the mean. But I think both beliefs are reasonable. We know it’s extraordinarily difficult to pick stocks that beat the market averages. For proof, look no further than the dismal performance of most actively managed mutual funds. But at the same time, there’s evidence that bad times in the broad market are followed by good.

When some investors use the phrase “reversion to the mean,” they use it in a strict sense, believing that the overall market always reverts to some average historical valuation or some average rate of return. But I don’t pretend to know what the market’s “mean” is. I don’t think there’s any guarantee that stocks will notch 10% a year, no matter how long we hold them, nor do I think the U.S. market is destined to revert to, say, its 100-year average of 17 times trailing 12-month reported earnings, with a dividend yield of 3.9%. (Today, stocks trade at 44 times earnings and yield 1.4%.)

But I do firmly believe that, when stocks next plunge, good times will return. Why? The stock market’s performance roughly reflects the economy. As the economy grows over time, corporate earnings will increase. In the short term, investors may be more concerned about, say, rising interest rates, political upheaval, accelerating inflation or higher taxes. But sooner or later, they’ll take note of those rising corporate profits and bid up share prices.

What are the investment implications? Instead of panicking when stocks plunge, we ought to feel confident that our portfolio will come back. But our degree of confidence should vary with our investment strategy.

If we own the broad stock market through, say, total market index funds, we know our portfolio will rebound along with the market. That means that, when stocks next nosedive, we should be prepared to rebalance our portfolio, adding to our total stock market index funds, so we maintain our portfolio’s target stock percentage. This will strike some as heresy, but I think that—if a market crash is severe enough—going even further, and overweighting stocks, is a reasonable strategy.

That said, we shouldn’t expect almost immediate gratification, like that enjoyed by those who bought in late February and early March 2020. The recovery from the next stock market crash may take far longer than we would like. Remember 2000-02? U.S. stocks suffered three consecutive losing years. Markets ought to return to their previous all-time highs, but it doesn’t mean they’ll do it quickly.

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What if we’re overweighted in, say, growth stocks or value stocks? We can still be confident—but perhaps not so much. In a broad market rally, both growth and value stocks will gain, but there can be big differences in performance. Ditto for large and small stocks, and U.S. and international.

In other words, during a stock market decline, rebalancing from bonds and cash investments to the broad stock market is likely to pay off. But if value stocks outpace growth stocks in any given calendar year, which seems likely in 2021, rebalancing at year-end from value to growth could hurt results. To be sure, if the performance gap is large enough and it goes on for long enough, mean reversion among market segments ought to happen eventually. But different segments of the global stock market can stay out of favor for a decade at a time, as we saw over the past 10 years, when U.S. large-company growth stocks soared, while value stocks, smaller companies and international markets struggled.

One implication: We should be slow to rebalance such market segments. For instance, I have a small-cap value index fund, which—after a long period of lackluster performance—has finally started generating decent returns. I’m in no hurry to lighten up on small-cap value and rebalance back to my target percentage because I figure this trend could run for many years.

What about individual stocks? While the entire stock market and broad market segments should revert to the mean, there are no guarantees with individual companies. In fact, history tells us that most companies suffer subpar stock market performance and have very short lives. The upshot: If you own an individual stock that’s struggling, I’d think long and hard before doubling down. Instead, I’d ask whether the market knows something about the company’s prospects that you don’t—and whether the wise move would be to sell and move the proceeds into a broadly diversified fund.

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.

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Richard Gore
Richard Gore
3 months ago

The latest forecast by GMO is that annual real returns for U.S. stocks for the next 7 years will be around negative 8 %. Mean reversion can work both ways.

Although few stocks will be immune from the general trend, I’m more comfortable owning a basket of select dividend paying stocks than I am of owning the market as a whole.

Last edited 3 months ago by Richard Gore
AnthonyClan
AnthonyClan
3 months ago

Or in other words: Never bet against America,” Warren Buffett…. If you believe this, then the long term mean will be positive. If not, then I guess your best bet it to go international.

Gary Palmer
Gary Palmer
3 months ago

I forgot, the market always moves in the direction which produces the maximum number of fools. Exhibit one, last week.

Gary Palmer
Gary Palmer
3 months ago

I think the trend toward shorter downturns, or put another way, quicker recoveries of market pullbacks, is a function of the greater awareness and acceptance of the “buy the dip” strategy. If you look at a 100 year chart of the S&P 500 the ever increasing upward trending line reinforces the conclusion that buying dips is the only strategy which can work over time, since we have absolutely no idea what the market is going to do in the near term. Meanwhile the 60/40 portfolio is dying a slow dearth as long bond rates stay as low as they are, pushing equities up further.

Roboticus Aquarius
Roboticus Aquarius
3 months ago

I think many of us struggle someway in the tug of war between consideration of valuations and momentum/trend, and also the reasons that underlie it all. We’ll never know these things for sure except to some degree in hindsight.

Value and growth… I’m not convinced either has some intrinsic benefit, or represents a valid ‘factor’.

I finally settled on a portfolio that’s about 80% constant. The other 20% doesn’t vary much, but shifts slightly based on a measure of momentum. It seems to net me about 40 basis points a year in doing so, but that could well be noise in the system. The main thing is that it keeps me happy rather than restless.

The kicker is that if I had to abandon the portfolio for a couple years, no big deal. It’s never so skewed that I can’t live with it long term.

Last edited 3 months ago by Roboticus Aquarius
Steve Spinella
Steve Spinella
3 months ago

I think I understand “random walk” differently. If we were able to control the stock market or an individual stock with two dials, one might be the trend and the other might be the randomness. If we could turn the randomness to zero and the trend to 10, everything would look smooth. The “random walk” says that the randomness is high enough, and the trend is low enough, that the travel and direction between yesterday and today appears completely random. If we could look out far enough, or lump together enough disparate elements in our basket, we hope the trend will emerge from the metaphorical bushes and we will see the forest as a whole.
There may be two slight flaws in the application of this: 1) very large companies might already be smoothing out a lot of randomness, just as very large indexes do, so our smoothing efforts might not make as much of a difference as we’ve been told. (Similarly asset classes, capitalization brackets, etc.) 2) There are still “secular” trends, and these may not head the direction we expect. They may also be taking a “random walk” over years, decades, centuries, or millennia.

Cammer Michael
Cammer Michael
3 months ago

Regardless whether the market is a random walk or reverts to an inflation adjusted mean (is there a difference?), there is are fundamental problems with looking at stock market trends long term. One is that we need money at specific times, some of them unpredictable times, and a stock market trend is irrelevant at those times; all that matters is that moment’s specific value. A second is that we have finite lifetimes and stock market trends are both longer and more abstract than this.

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