John P. Hussman, Ph.D.

Hussman Strategic Advisors
Wine Country Conference, 2014
to benefit the Autism Society of America

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Identifying mean reversion
Identifying mean reversion
Identifying mean reversion
Notice that
subsequent
change is
inverse to
the present
level.

Identifying mean reversion
Standard mean-reverting process
X
future
= X
today
* (M/X
today
)^{1 – e
-aT
}

Where a is the “adjustment speed”, M is the mean, and T is the time to future

The future % change in X will be proportional to log(M/X
today
)
When X is well above the mean M, future change will be negative
When X is well below the mean M, future change in X will be positive

If we have some “Fundamental” F that is representative of the mean M, then the
future % change in X will be inversely related to the present log(X/F)
This result holds even if M and F grow over time.

We test mean reversion in X not by examining X itself
but by relating X to some representative fundamental F
then checking whether future changes in X are inverse to the present X/F

* Geek’s Note: Technically, we expect future % changes in X to be inverse to the current level of log(X/F)



Hate math?
Just
remember
this
Mean reversion is hard to detect directly
The level of X isn’t enough to tell the story
The real tipoff: Future market returns are
inverse to present log(price/fundamental)
Why an equity bubble isn’t obvious
Profit margins are 70% above their historical norm, for
reasons that have a great deal to do with the present
economic cycle, but should not be expected to persist.

“Profit margins are probably the most mean-reverting
series in finance, and if profit margins do not mean-
revert, then something has gone badly wrong with
capitalism.”
- Jeremy Grantham
Why should we care?
 We do not care about profit margins out of concern that
earnings will decline over the next few years and stocks will
fall as a result. While both may happen, the fact is that
market changes usually have little correlation with short-
run changes in corporate profits.
 We care about profit margins because stocks are a roughly
50-year duration claim on future cash flows. By thinking
that stock prices can be valued as a simple multiple of
today’s earnings, investors are using today’s earnings as if
they are representative of that entire long term stream… for
decades, and decades, and decades to come.
Does profitability mean-revert?
The test of
mean-reversion
is whether
subsequent
changes run
inverse to
present levels.
So far, they do.

Does profitability mean-revert?
Not everyone
likes my use
of CPATAX.
Other variants
don’t change
the basic story.

Corporate profits are a mirror-image of
deficits in other sectors
We know why
margins have
been elevated.
Nothing in
this dynamic
has changed.

Until recently, slow real wage growth has
supported profit growth.
We know why
margins have
been elevated.
Nothing in
this dynamic
has changed.

The Iron Law of Valuation
 Every security is a claim on some expected stream of future cash
flows that will be delivered to the investor over time.

 The higher the price an investor pays for that stream of cash
flows, the lower the expected return.

 The lower the price an investor pays for that stream of cash
flows, the higher the expected return.

 A reliable valuation fundamental “F” acts as a “sufficient
statistic” that maintains proportionality to those long-run cash
flows. So the higher the ratio of Price/F, the lower the long-term
expected return, and vice versa.
Current earnings can be terribly unrepresentative
as “sufficient statistics” for long-run cash flows

“Observation over many years has taught us that the
chief losses to investors come from the purchase of low-
quality securities at times of good business conditions.
The purchasers view the good current earnings as
equivalent to ‘earning power’ and assume that prosperity
is equivalent to safety.”

- Benjamin Graham
Margins and multiples matter jointly
Margins and multiples matter jointly
Margins and multiples matter jointly
Expected 2-year total returns
Valuations
do not reliably
mean-revert at
short horizons.
Error bands are
very wide.

Expected 3-year total returns
Significant
errors even
at 3-year
horizon

Expected 5-year total returns
Range and
frequency
of errors
improving at
about 5 years,
but still large.

Expected 7-year total returns
Range of error
narrowing.
Zero expected
return at this
horizon.

Expected 10-year total returns
Prospective
10-year total
returns about
2.4% annually

Expected 15-year total returns
Prospective
15-year total
returns still
only 4.4%
annually
Expected 20-year total returns
Prospective
20-year returns
only about 5.5%
annually here.
Note slightly “off
phase” profile.
Prospective returns are negative at
horizons of less than 7 years
Reliable valuation measures are double historical norms
Reliable valuation measures imply weak future returns
It’s not different this time.
 “Reversion to the mean is the iron rule of the financial markets”

– John Bogle

 “Many shall be restored that are now fallen; and many shall fall that are now in
honour.”

– Horace Ars Poetica as quoted in Security Analysis by Benjamin Graham and
David Dodd

 “I got wiped out personally in 1968, which was the last really crazy, silly stock
market before the Internet era… I became a great reader of history books. I was
shocked and horrified to discover that I had just learned a lesson that was
freely available all the way back to the South Sea Bubble.”

– Jeremy Grantham


Addenda: Shiller P/E
Adjusting for
profit margins
embedded in
Shiller earnings
(which matter!)
the Shiller P/E
would presently
be above 30.
Median and mean price/revenue
A “hideous opportunity set” – James Montier
Consequences of yield-seeking

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