Why the Mean Reverters are Wrong
Unlike most of the developed world, Australia’s economy grew quickly after the GFC and is on track for good GDP growth next year and onwards. We aren’t saddled with the baggage of unsustainable deficits like the US, nor with the structural decay of the UK and most of Western Europe. Our banking system is the best in the world, our economy is more open and flexible than Japan, and we export massive amounts of commodities. Australia is directly leveraged to world growth, and is riding the wave of industrialization in emerging economies like China and India. Why then do the same old pessimistic comments from traditional fund managers still get airtime: the doomsayers tell us that our market and share prices won’t keep growing, because corporate earnings ‘can’t’ keep growing at the pace they have in the last decade or so. This is a statement about ‘mean reversion’, which in the case of traditional fund managers commenting on equity markets means that they expect the markets to conform to growth patterns which reflect the very long term average levels seen in the past. This statement is pure hokum!
Last week’s media coverage about Australia’s massive population growth ‘immature’. In the northern hemisphere, the only hope for a radical change in growth patterns will come from radical structural reform – massively difficult within a gridlocked political system like that prevailing in most western economies. The malaise for these countries is compounded by their rapidly ageing populations – which further distresses national budgets as costs of welfare rise, but the taxpayer base falls. Japan’s population is predicted to fall by 30% this century.
Arthur Sinodinos was the Chief of staff to PM John Howard and writing in last week’s The Australian, he applauded the benefits which population growth can deliver. Carefully managed population growth is a GDP growth driver. Immigration drives growth in the housing, food, transport, education, healthcare, and financial services sectors – to name a few. In addition to the organic economic growth coming from Australia’s resource exports, its Australia’s population growth that will underpin continuing economic growth – driving accelerated corporate earnings for quality Australian companies.
Let’s look at the other reason why the concept of mean reversion is hokum. It’s a dictum arising from the convenient assumptions that underpin the efficient market hypothesis. Recall this is a simplified model of the economic landscape and assumes that markets behave rationally. The EMH assumes that we all have equal access to all relevant information about investments; that we all react the same to that information; that we all have unlimited and equal access to leverage; and that none of us pay taxes. Since EVERY single one of these assumptions is never completely accurate, it’s clear that the EMH and any models that it generates (such as the notion of mean reversion) will never be completely accurate either. The GFC showed us how unrealistic the EMH model really is – there were specific anomalies at play in the reaction from global investment banks and hedge funds (caught out by overleverage) that made them react to falling asset prices far differently than individual investors reacted. (By the way, that’s why the SMSF and DIY investor will always do better in the long run than compared to relying on pooled investment vehicles like traditional managed funds). Few if any knew how much leverage was really at work in the system – and when that bubble burst, access to borrowing was curtailed for most investors. And tax rates are different for pension funds in most countries compared to retail investors. The EMH is a simplistic view of the world, and it’s the behavioural anomalies of real investors that destroy its validity as an investment management tool in the real world).
Mean reversion is a mathematical concept that can definitely be observed in activities that are not influenced by the behavior of the participants and instead simply rely on chance, such as coin tossing or dice throwing. Played often enough, coin tossing will produce a 50/50 split between heads and tails. If a run of heads for a certain period makes the outcome different to 50/50, then all that needs to be done to get the outcome back to 50/50, is to play the coin tossing game for longer. This is the concept of mean reversion.
BUT – markets aren’t just games of chance. There are organic changes at play, like Australia’s population growth. It’s completely irrational to assume that markets must revert to typical long term behavior, just because that has happened in the past is no guarantee that it will happen in the future. The complete perversity of the mean reversion argument is that it’s adherents suggest that we should be investing in countries that have suffered from the GFC – like the US – because it’s expected that they MUST recover back to their long term average growth levels. Since the US clearly is in a secular bear market, this is a very dangerous position to adopt. Since it’s the position that most traditional fund managers place themselves in, it’s no wonder that the mean reverters are a dying breed.
And by the way – realizing that mean reversion is unlikely to drive Australia’s growth back to lower levels than experienced in the last decade – the long term, “buy and hold” approach to direct share investing is sure to remain a winner in Australia for the foreseeable future. Volatility, however, will be its twin for some years to come.
© Alpha Structured Investments
