John Hussman: Really Mean Reversion

May 13, 2014

by Robert Huebscher

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In his most recent commentary, GMO’s Jeremy Grantham said value investors are destined to endure pain in a market bubble, especially in its latter stages, as clients scorn them for missed opportunities. John Hussman is surely one such investor – indeed, Grantham’s commentary drew extensively on John Hussman’s research. In a recent talk, John Hussman explained why he, Grantham and other long-term value-driven investors should be worried, even if equity markets perform well in the short run.

“Investors who hope to capture the last throes of a bull market don’t realize how quickly they will lose that on the way down,” John Hussman said.

Reversion to the mean will cause equity prices to fall — countless observers have used metrics such as the Shiller cyclically adjusted price-to-earnings ratio (CAPE) or Tobin’s Q ratio to explain this. But John Hussman went beyond that, providing a model that improves on conventional ways of predicting market prices. He offered some predictions as to when the correction will occur.

John Hussman spoke on May 2 at the second annual Wine Country Conference in Sonoma, sponsored by Sitka Pacific Capital Management. This event has turned into one of the best opportunities to engage with top-tier speakers in an intimate setting – and to enjoy one of the best locations of any conference you’re likely to attend. All proceeds from this year’s event were donated to the Autism Society of America, and I encourage readers to consider this worthwhile cause.

A copy of John Hussman’s presentation is available here.

Let’s look at John Hussman’s explanation of how reversion to the mean operates and what prospective equity-returns investors are likely to obtain over various time frames.

The dynamics behind mean reversion

John Hussman offered a detailed explanation of the mathematics behind mean reversion but said one only needs to answer a simple question to determine whether a variable – such as equity prices – is mean reverting. Let’s assume there is another fundamental variable (e.g., the market-capitalization-to-GDP ratio) that is representative of the mean. Are future changes in one variable (equity prices) inversely correlated with the current level of the fundamental variable (market-cap-to-GDP)?

In the case of equity prices, a high level of market-capitalization-to-GDP ratio is correlated with poor subsequent stock-market returns, and vice versa. That assures that equity prices and stock-market returns mean-revert.

John Hussman provided the historical examples to validate this assertion – data which will be very familiar to readers of his weekly market commentaries. Low market-capitalization-to-GDP ratios in the 1950s predicted high returns over the subsequent 30 years, and high ratios in 2000 predicted the poor returns equity investors suffered in the decade following the dot-com boom.

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