Market Analysis

Aversion to the Mean: Why Averages Don’t Predict Stocks’ Direction

Stocks’ gangbusters February doesn’t mean March must be a stinker.

Stop us if you’ve heard this one before: What goes up must go down, and what falls the furthest bounces the highest. If you are Galileo or Sir Isaac Newton and referring to physics, then yes. But in stocks, not so much. The statement assumes Extreme A is followed by an equal and opposite extreme, maintaining the long-term average—also known as reverting to the mean. But stocks don’t do that. If you see a forecast assuming they do, you can probably tune it out.

MORE: Interested in market analysis for your portfolio? Our latest Stock Market Outlook looks at key stock market drivers including market, political, and economic factors. 

We’re compelled to point this out because stocks did great in February. The S&P 500 rose 5.7%.[i] The MSCI World Index rose 5.9%.[ii] Right on cue, some pundits are warning March will probably stink, mostly because of February. One seemed surprised history doesn’t actually support this, calling it “slightly counter-intuitive” that the S&P 500 rose during the month following nine of the ten 5%-plus moves during this bull market. But that sample size is so small, it incorrectly leads readers to believe big months mean more big returns ahead! The truth is far more boring and less gameable. From 1926 through 2014, the S&P 500 rose 5% or more in a month 179 times.[iii] It fell the next month 59 times.[iv] That is a 67% frequency of positive returns, higher than the 62% frequency of positive monthly returns overall.[v] But that isn’t a predictive tool! It doesn’t mean big months beget positivity! It merely guts the notion stocks must mean revert after they go up nicely. Averages are just observations of history. Interesting factoids. Not objects with gravitational pull.

Mean reversion is everywhere. It’s in warnings the S&P 500’s high cyclically adjusted P/E ratio (CAPE) means stocks will soon suffer. It’s in the wallowing about above-average normal P/Es in the US putting a ceiling on equity returns. Neither of those statements are true. Both assume past performance predicts the future. They assume economic, political and sentiment-related factors stop moving stocks—the CAPE warning assumes gravity must take hold, the traditional P/E argument assumes stocks can rise only if earnings do. That ignores a long history of multiple expansion during mature bull markets as investors gain confidence and get ever-cheerier about the future.

Mean reversion also underlies myths about sector and country performance. At the end of every year, headlines treat us to lists of the best and worst sectors, and there is a school of thought that says buying the prior year’s worst performer is an easy ticket to riches. That would be lovely, but it isn’t true. As Exhibit 1 shows, the worst sector has been the following year’s best sector just twice in the last 25 years. Sometimes the worst was worst twice in a row. Sometimes it was meh the next year. On a country level, if you sample the 22 MSCI World Index countries with returns back to 1990, the worst performers have never beaten the pack the following year. They’ve repeated as worst twice (Ireland in 2007/2008, Finland in 2003/2004) and been in the bottom tier plenty.[vi]

Exhibit 1: Best and Worst Sectors

exhibit 1

Source: FactSet, as of 2/27/2015. Annual returns for each sector in the S&P 500, 1990 – 2014.

Stocks pretty efficiently discount all widely known information—mean-reversion expectations are widely known. Plus, for every mean-reversion devotee there is a momentum junkie who believes the trend is always your friend—on the upside and the downside. What goes up keeps going, what goes down keeps going. Markets price in these and all other competing expectations. And then do something different. If this weren’t the case, market returns would be perfectly predictable and follow set patterns, and no investor would lose money ever.

Now, sometimes stocks do things that look like mean reversion, like bounce high after bear markets. You also see it in categories like small cap, which often get over-punished in bear markets and bounce highest when bulls begin. Observations like this are why mean-reversion mythology persists—confirmation bias. But these instances aren’t physics—they’re sentiment, as investors realize their expectations were too irrational as the bear bottomed. This also doesn’t apply broadly, as the sector that leads a bear market down tends to lag during the recovery as investors fight the last war. Markets live to keep us all guessing.

Anyway, none of this tells you where stocks go in March, which doesn’t matter anyway because it’s very short-term. Regardless of whether March becomes the 10thpositive month to follow a 5%-plus month during this bull market, stocks look poised to rise over the foreseeable future. Just with some bouncy-wouncy along the way. Don’t overthink it or get caught up in the short-term hoopla.[vii]

[i] FactSet, as of 3/2/2015. S&P 500 Total Return Index, 1/30/2015 – 2/27/2015. If you see “around 5.5%” or “just under 5.5%” quoted as the S&P 500’s February return elsewhere, they are referring to the price index, which doesn’t include dividends.

[ii] FactSet, as of 3/2/2015. MSCI World Index returns with net dividends, 1/30/2015 – 2/27/2015

[iii] Global Financial Data, Inc. and FactSet, as of 3/2/2015. S&P 500 Total Return Index monthly returns, January 1926 – February 2015.

[iv] Ibid.

[v] Ditto. Which we used instead of “Ibid” for anyone who was getting bored by the series of non-joke footnotes.

[vii] Sorry for being so, well, mean.