Diversification allowed a portfolio to avoid much of the drawdown until September. Figure 2 shows the cumulative 2008 performance of an equally weighted (EW) portfolio of the 16 asset classes in Figure 1 and Table 1 with the performance of a traditional 60%/40% U.S. stock/bond mix (with stocks represented by the S&P 500 Index and bonds represented by the Lehman Brothers Aggregate Bond Index). Note how the diversified 16-asset approach largely avoided significant losses and dramatically outperformed the 60/40 mix until September. In the end, with almost everything producing historic losses, asset allocation was largely futile. Of the 16 asset classes, 15 finished September in the red, which resulted in the equally weighted basket producing a return of –6.74%. The magnitude of this loss was exceeded only by the decline of –8.34% of August 1998 (largely ascribed to the collapse of Long-Term Capital Management). The five worst months since 1988 are presented in Figure 3.
Although painful, this correction has led many asset classes to offer reasonable—and in several cases, impressive—forward-looking premiums for bearing risk. This situation was not the case in the past few years; investors evidently felt entitled to higher and higher returns for bearing less and less volatility. Many of our friends and clients have heard us remark in recent years about the dearth of “low-hanging fruit”—that is, markets that are attractively priced relative to both other markets and their own history. Today, low-hanging fruit abound. Indeed, almost too many markets are attractively priced!
Risk premiums have a habit of nearly always drifting back to an equilibrium—which is what we mean by “mean reversion.” The reversals may, however, cause prices to snap back “too much” relative to a “reasonable” level. Too small a forward-looking risk premium quickly becomes too large a premium. Today, we are actually witnessing in some categories forward-looking risk premiums well above historical norms for the first time in many years. This situation is good for those who will be net purchasers of assets. It doesn’t do much to ease the recent pain, but it reminds investors that it is always darkest and coldest right before dawn. We think the next few months will afford buyers some of the best opportunities in years to embrace risks that others shun and wade far afield in our search for attractive asset allocation opportunities.
Mean Reversion in Equities
The phrase “What goes up must come down” applies equally well to Newton’s apple and the stock market. No individual stock—nor, for that matter, asset class—will outperform peers forever. Inevitably, prices adjust. We illustrate this powerful trend with an examination of the top 10 U.S. stocks by capitalization through time. And we explore how investors can benefit from mean reversion in the current markets.
Of course, there are two ways a stock can make it on to this exclusive top 10 list—it is a large company whose future results will validate its lofty ranking or it is overvalued, perhaps dramatically so. These overvalued shares presumably have recently experienced dramatic run-ups in price to make it into the top 10. This is where mean reversion comes into play. The market will realize expectations for these stocks have gotten ahead of themselves and they will revert to some price level that more accurately reflects future prospects.
The performance implications of mean reversion for capitalization-weighted indexes are huge because the top 10 companies have the largest weights in the index. Thus, their subsequent underperformance will bring the whole index down. This outcome is easily seen in Table 2, where, on average, only 3 of the top 10 stocks by capitalization outperformed over the subsequent 10 years and, cumulatively, all 10 underperform the average stock by almost 30%.
In 2007 and 2008, amazing turnover has occurred in the top 10 stocks in the cap-weighted S&P 500. Comparing the top 10 list for June 30, 2008, with the list for year-end 2006, we discover that 5 of the top 10 are no longer on the list. Not surprisingly, three firms were financial institutions—Citigroup, Bank of America, and AIG. Altria Group (consumer staples) and Pfizer (health care) also faltered enough on a relative basis to drop out of the top 10. AT&T was a replacement by way of its merger with SBC Communications. The four new stocks outperformed their peers enough to climb into the top 10. Two of the additions rode the wave of “black gold” prices—the energy twins Chevron Corporation and ConocoPhillips. The other two are in information technology—Apple Computer and IBM—which has traditionally been a high-beta sector and held up well in the recent market downturn.
If a market is efficient, nothing is wrong with allocating more to recent winners. In a random walk, recent winners are just as likely to outperform as the stocks that have faltered. But a random walk is not what has occurred historically, and it didn’t occur in the third quarter of 2008 either. The five new additions to the S&P 500 returned on average –17.5% for the quarter versus –8.4% for the S&P 500 as a whole and –7.9% for the average stock.1 Large-cap U.S. stocks faced a tremendous headwind during the third quarter.
If a market is less-than-fully efficient, index investors will benefit from indexing strategies that break the link between price and portfolio weight. The Fundamental Index™ methodology does exactly that. It selects and weights stocks in an index on the basis of their fundamental size (as measured by sales, cash flow, book value, and dividends) and rebalances back to those weights on an annual basis. The stocks whose prices have surged well ahead of their fundamental size, their underlying economic scale, are sold and the proceeds are used to purchase stocks whose prices have cratered relative to changes in fundamental size. Intuitively, one can see that this rebalancing offsets some of the problems with holding large allocations to recent winners—which are headed for a reversal. Large capitalization stock indices by over-allocating to these recent winners faced a tremendous headwind during the third quarter.
Of course, this trend won’t occur every quarter or, for that matter, year. We can be relatively confident, however, in the mean-reversion process repeating. Trees don’t grow to the sky, and an individual stock won’t outperform forever. Successful companies see their stock prices rise simultaneously with investor expectations. Human nature conditions investors to favor investments that have been profitable recently and to extrapolate recent earnings and revenue gains well into the future, which causes valuations to rise beyond the reasonable and sets the stage for mean reversion.
Looking Back and Forward
In a volatile market like today’s, two approaches provide insurance against the price reversals—a disciplined, relative-value approach to asset allocation in the broad capital markets and an indexing approach that anchors on metrics of fundamental size rather than capitalization. Both are critical in the face of an uncertain and unsettling investment environment.
Trying to pick market peaks and troughs is folly. But buying investments that most investors fear has always been one of the most powerful tools in an investing toolkit. Recent years have afforded few opportunities to follow this strategy. So, we relish the opportunity to be more bullish, in many markets, than most investors. The “permabears” are, albeit selectively, exuberantly bullish. We think that the months ahead will afford the patient long-term investor some of the most promising investment opportunities in many, many years. We think that, five years hence, we will look back on the next few months as the foundation for extremely profitable investment choices.