Mean reversion the idea that things are generally cyclical and will tend to return to their long-run average over time is a key belief in value investing. However, "it can be very dangerous to assume that things are never different", warns Jeremy Grantham of US wealth manager GMO. Since 1996, the average price/earnings (p/e) ratio of the US stockmarket has been 23.36, compared with 13.95 for the period from 1930 to 1995. The Shiller p/e, which averages earnings out over ten years, rather than taking just one year, tells a similar story: in the last 25 years, the market has spent only six months below its long-term trend.
So what's changed? Corporate profit margins are higher, which could justify higher valuations. This is partly due to the Federal Reserve keeping interest rates ultra low (and borrowing cheap) since 1997. Yet it's not all down to low rates, says Grantham. Corporate profits typically mean revert too so in a reasonably competitive world, "higher margins from long-term lower rates should have been competed away". Why haven't they? Because corporations have more power than they did. That's due to globalisation (which has increased the pool of available labour, and boosted the power of global brands), and increased regulation (which make it harder for competitors to muscle in on a market).
Grantham expects corporate margins to expand further this year, assuming a "moderate" cut in US corporate tax rates. Lower rates are "likely to be with us for years", so value investors will have to be patient we could well see "a 20-year limping regression that takes us two-thirds of the way back to the good old days pre-1997".
MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
-
Steve Webb: The triple lock is there to do a job. I’m not embarrassed or ashamed of itThe triple lock means 13 million pensioners will now get an above-inflation state pension boost in April. While the rising cost of the policy has stirred controversy, Steve Webb, who served as pensions minister when it was introduced, argues the triple lock is vital and should stay. Webb speaks to Kalpana Fitzpatrick on the new episode of MoneyWeek Talks – out now.
-
How retirement pots risk running out 11 years early if inflation remains highPension savers could find their retirement income may not last as long as they anticipated over fears that inflation may not slow down
