Many investors refuse to participate in the market from time to time because it is, in their opinion, “over-valued.” Definitions and opinions on what constitutes over-valuation vary widely. Any given day, you can read pundits in the financial press declaring both over- and under-valuation at the present time. Whatever the proper valuation is, it’s a pretty nebulous concept.
CXO Advisory shared the results of a paper that looked at the reversion of stock markets to a valuation benchmark based on a world stock market index. In other words, when the market is over-valued does it make sense to wait around for it to correct back to the mean? Or should we just go with the flow, keeping in mind Keynes’ maxim, “In the long run, we are all dead”?
CXO concluded:
…evidence indicates that speed of reversion of stock markets to a valuation benchmark is not reliable over an investing lifetime.
They reached this conclusion because, working with a huge 109-year data sample, the study showed that correcting divergences took a long, long time:
On average over the entire sample period, stock markets eliminate half of a divergence from the valuation benchmark in about 13.8 years…
The 95% confidence interval for correcting half the divergence was a span from 10 to 21 years. Yikes! When something gets out of synch, it can stay that way for a long time. An investor probably will not have the luxury of waiting around for the market to go where it is theoretically supposed to. In this context, following the current trends in markets to extract returns today may be a more realistic option than waiting around for markets to behave themselves tomorrow-or 15 years from now.
Yikes indeed.
“–or 15 years from now.”
How prescient. This is what I learned (from you): that markets can stay overbought or oversold for longer than we expect. Not many have 13.8 years to get serious (before they cry “uncle”), let alone 109. Not many can stay the course. Drawdowns are a killer.
Lets see - 13.8 x 2 = 27.6… … I’ve always wondered that/why things happened in 7-9, 18, or 27 year cycles, and that events are definitely not reliable/bankable over an investing lifetime.
Serious stuff. Good post.