Regression to the Mean
A DR Classique, first aired August 1, 1999…
This essay was inspired by vacation reading – Peter Bernstein’s Against the Gods . Anyone who is serious about investing should read it.
Charles Darwin’s cousin, Francis Galton, was fascinated by heredity. His illustrious family included far more great thinkers and achievers than mere chance would allow. Yet, when he studied the issue, he discovered that it was rare for greatness to persist in a family. A very accomplished parent would be likely to have children who were ordinary. This led him to the principle that we all know as "regression to the mean."
It is the principle we are applying to the stock market when we expect prices to return "to normal." But it has a couple of built in complexities. The most important of these is this: how can you know what’s normal? Much of life seems cyclical. The sun rises…it sets. Tides come in and then go out. Kondratief got sent to Siberia for finding long cycles in capitalism. But does human activity merely repeat itself over and over like the movie Groundhog Day?
Well…not exactly. In the 1960s…a new era began in US markets. The age-old relationship between stocks and bonds changed. Henceforth, people would be willing to accept stocks with dividends lower than the yield on bonds. This change was caused by another major change – the dollar was no longer backed by gold…and no longer a reliable store of value. Bonds were particularly susceptible to inflation…so people demanded higher yields.
This led a number of financial analysts – including many of my friends – to believe that things had changed in a much more fundamental way. They believed that the dollar would soon disappear…that gold would rise to almost infinite heights in dollar terms…and that bonds were merely "certificates of guaranteed confiscation."
But the market is a very tough competitor. When you think you have it figured out…it does something unexpected. It reacts to efforts to understand it…and frustrates attempts to profit at above market rates. That is why winning strategies do not hold up over time. The Dogs of the Dow concept was hot in the 80s. Then, people began using it. They bid up the prices on the dogs to the point where the strategy would no longer work. In the five years from March ’89…funds focused on international stocks went up 20%…the best performing sector. During the next 5 years they were the worst. Seeing that it was almost impossible to beat the market, investors loaded up on index funds and Dow stocks. And now that strategy, too, no longer seems to be working.
Still, regression to the mean is a fact. Markets do not go up forever. Everyone can’t become infinitely rich. Trees do not grow to the sky. There are limits, in other words. And the further a system goes away from its apparent mean…or centre…the more likely it becomes that it will reverse direction. At least…that is what I have always thought, intuitively.
If the direction of the market is completely random… and thus unpredictable…the pattern of up days and down days will follow the normal bell curve of random distribution. Two Baylor University professors plotted it out. Sure enough, they got a bell curve. In any given month, the odds that it will go up or down are little different than a coin toss (allowing for a slight upwards bias over time).
But there is something funny about this bell curve. When you look at both ends, you see that they have humps on them. This is not an ordinary bell curve, in other words, which feathers out to nothing at the extremes. This bell curve shows a lot of action at the extremes. Peter Bernstein’s description:
"The chart of monthly changes does have a remarkable resemblance to a normal curve. But note the small number of large changes at the edges of the chart. A normal curve would not have those untidy bulges."
I think we are on to something big here…something that analysts have not noticed. It is probably true that stock market timing is usually a waste of time. Most days, most months, most years, the market direction is simply unpredictable, like the toss of a coin. But when the market is either very underpriced or very overpriced…at the extremes…nature asserts itself with a powerful tug back to the mean. Thus, when he sees the market at an extreme, the prudent investor should adjust his portfolio in the expectation that the market will regress to the mean, however inexact that may be.
Here’s how Bernstein puts it: "At the extremes, the market is not a random walk. At the extremes, the market is more likely to destroy fortunes than to create them. The stock market is a risky place."
Is the market at an extreme today? Or what?
August 26, 2002
We’re out here in the French countryside…waiting…
Waiting to find out if this rally is (1) the beginning of a new bear market…(2) just a typical bear market rally or (3) already over.
The S&P has risen for 5 weeks in a row. But volume has been low – as you’d expect in the late summer – and on Friday the Dow fell 180 points and the Nasdaq lost 3% of its value.
Our hunch is that we’re looking at a bear market rally near its end. When the rally began stocks were priced at levels usually seen at tops, not bottoms, with the S&P yielding less than 2%. When the real bottom comes the yield will be 3 or 4 times that much, we predict.
Readers will recall a book written at the peak of the bubble – "Dow 36000." The book’s premise was that stocks should sell at much higher prices because they were not nearly as risky as people thought. The idea was nonsense from the get-go, of course…a reader had only to look across the wide Pacific at what had happened in Japan to see that stocks were very risky; even in the ’90s they could go down and stay down for at least a decade.
And now, nearly three years into a bear market in America, there can hardly be any doubt that stocks are a dangerous place to put your money. The risk premium is there for a good reason!
We’re waiting to find out what happens in the housing market, too. By way of background information, Alan "Mr. Bubble" Greenspan created more new money than all the other Fed chiefs combined. In fact, according to Jonathan Van Eck, he brought more money into existence than all the presidents, treasury secretaries, bureau of printing and engraving honchos, and Fed chiefs combined…since Washington took the oath of office in 1788. Where did all that new money go? It went into stocks until the year 2000. More recently it has found its way into real estate. Mortgage refinancings are running 100 percent ahead of last year.
Goldman Sachs reports mortgage borrowing currently rising at an annual rate of more than half a trillion dollars. Of the refinancings, 67% are increasing the size of their mortgages by at least 5%, with the typical mortgage only 4.1 years old on a house that has increased in value by 23%.
People think they are ‘taking out equity.’ But mortgages that young have very little equity in them; most of the mortgage payments go to cover interest. Instead, they are taking out the inflated value of the house. Our London correspondent, Sean Corrigan, has more, below.
We’re waiting to find out what happens next. House prices cannot continue to rise at 3 or 4 times the rate of personal incomes; who will be able to buy them?
And when house prices stop inflating…will they begin deflating? And will they begin deflating the entire consumer economy? We’re just waiting to find out…
"Sales softened in August," Radio Shack reported, not waiting for the end of the month, "and despite promotional activities to stimulate business we have been unable to overcome the falloff in consumer demand."
"Too much supply, too little demand," says a Washington Post headline, emphasizing the problems of the airline industry.
If and when real estate prices stop rising…and mortgages stop being refinanced…the consumer economy falls apart.
At least, that is our prediction…based on what happened in Japan. We wait to find out if it is right.
We’re also waiting to find out what happens to the dollar. It fell. Then, it rallied along with stocks. Briefly worth more than a dollar, you can buy a euro today for only 97 cents. If we’re right…and both stocks and the dollar are in long-term bear markets… this would be a good moment to sell them both.
Sell the rallies; don’t buy the dips.
I’m still on vacation. Eric’s still on vacation. We hope Addison will be returning from the wilds of the New World sometime soon. In the meantime, our eyes and ears in London, Sean Corrigan, brings you a special report on the US housing market…
Sean Corrigan, reporting from England:
– How long will it be until we get zero-finance homes, to go along with the cars? In the desperate urge to translate as much as possible of the inflationary asset- credit spiral in housing back to their own bottom lines, America’s mortgage lenders have begun to address the looming affordability problem in the US by importing a range of tricks more typical of the UK market.
– Not content with the lowest long-term mortgage rates since Elvis was skinny, home-owners – with the collusion of lenders and appraisers – are resorting to all manner of ruses in order to make their incomes stretch far enough to cover that house payment.
– At California-based Countrywide Credit, owners with existing 30-year loans at around 7% have been able to refinance at 6% without paying a dime in closing costs – "nirvana for home owners," Countrywide chief executive Angelo Mozilo told the Charleston Daily Mail, while rubbing his hands together in glee at the fact that his company is on pace to originate $170 billion in loans this year. "And it’s accelerating," said Mozilo, after July alone hit $17.1 billion.
– Don’t even stop to think about the fact that this company, with equity of around $4.5 billion, "services" a portfolio of $400 billion in loans – it’s all right, he assures us: all risk is "hedged" using derivative instruments.
– But low rates by themselves are not enough. What is helping juice this late cycle phase are the multiplying alternatives to traditional fixed-rate and adjustable- rate loans.
– Some of these new products reduce initial payments by charging interest only at first (who needs to sweat to pay off the loan itself when prices are going to go up for years, right?).
– Others work by setting a lower fixed rate for three, five or seven years before converting to adjustable rates. Others are offered with virtually no down payments required.
– At Wells Fargo, consumer demand for a hybrid mortgage that is fixed for five years and then becomes adjustable has grown more than 150 percent from last fall. The Daily Mail quotes Brad Blackwell, a senior vice president at the San Francisco-based bank, as saying that consumers who refinanced their homes as recently as six months ago have been drawn back by rates that have continued to fall.
– Borrowers, especially those with loan amounts exceeding $300,000, "are flocking to this loan in record numbers," he said.
– Lending has also been spurred by the willingness of home-loan buyers such as New Deal hangover Fannie Mae and Wells Fargo to accept mortgages representing more than 100 percent of the appraised value of a home.
– Who said, "Prudential standards of lending?"
– "The credit spigots are as wide open as we’ve ever seen them," consumer loan expert Keith Gumbinger told the Daily Mail. "You can borrow money in excess of the value of your home. You don’t need a down payment, you don’t need any money for closing costs. Things could change, but for people with decent credit right now, if you can breathe you can get a mortgage."
– Walter Updegrave, CNN Money "specialist", recorded the following gem in response to an online query, "Is it a good idea to keep a home equity line of credit as an emergency fund?"
– "Yes," said our Wally, eagerly. "Yes, I think it’s a great idea to have a home equity line of credit as an emergency fund. With the economy so unstable, you never know when some financial problem may find its way to your door – a pink slip from an employer who has ‘right- sized’ you out of your job, unexpected medical expenses, college tuition bills. Being able to write a check against the equity in your home provides a quick and convenient way for you to meet unexpected obligations."
– Wow! That’s great! If we get into trouble, we’ll just sell off some capital. And capital we didn’t have to sweat to earn, to boot! How novel!
– "But," said Wally, suddenly revealing himself as a party-pooper, "It shouldn’t be your only basket of eggs. While I think it’s okay for a home equity line to be ‘an’ emergency fund, I don’t think it’s a good idea for a home equity line of credit to be your only emergency fund. Which is to say, I think your first line of defense in emergencies should be savings."
– Savings? Give us a break, Wally. "Savings" are what our grandparents did; we’re so over that.
Back at Ouzilly…
*** We’re waiting for our summer vacation to come to an end. After a while, leisure is more tedious than work.
*** Besides, the summer seems to have ended already. Gone are the sunny skies and sunny dispositions. It began raining yesterday and shows no signs of letting up. The aunts, uncles and cousins are gone. Anticipating school, Maria has returned to her math problems, Edward to his reading. Even Jules has taken up the schoolwork he was supposed to be doing all summer.
*** "I just spoke to your sister," began my mother last night, bringing us the latest news from Virginia. "It’s 97 degrees."
*** "Well, at least they can go swimming," said Jules enviously.
*** "No…Margaret said they couldn’t even use their swimming pools, because there’s a water shortage," his grandmother continued.
*** Sometimes…things go bad all together…and even the saving graces stop saving.