The Power of Mean Reversion

FIVE THINGS YOU SHOULD KNOW

1. Equity Markets – moved lower this week with U.S. stocks (S&P 500) down % and international stocks (EAFE) falling %  
2. Fixed Income Markets – rose this week with investment-grade bonds (AGG) up 0.14% and high yield bonds (JNK) up 0.24%
3. Fed Minutes – Minutes released from the December FOMC meeting signaled policymakers are comfortable leaving rates at restrictive levels “for some time” until a consistent decline in inflation is felt, but also acknowledged rates most likely have peaked. While the notes gave no indication of when the Fed may start considering rate cuts, it did suggest increased optimism on the current path for inflation.
4. Jobs Report – The number of Americans filing for unemployment benefits sank by 18,000 to 202,000 in the last week of 2023, firmly below market expectations of 216,000 to mark the lowest claim count since October. In the meantime, continuing claims fell by 31,000 to 1,885,000 in the earlier period, signaling that individuals are having an easier time finding new employment. The data matched other recently released gauges in underscoring the historical tightness of the US labor market, adding leeway for the Federal Reserve to prolong its hawkish stance into 2024
5. Key Insight – [VIDEO] This week Jake introduces our newest team member, Amy Jo. [ARTICLE] While it’s natural to feel compelled to chase what’s been hot or run from what has struggled, the reality of mean reversion in markets demands investors have the discipline to usually do the exact opposite as we’ll explain below.

INSIGHTS FOR INVESTORS

Intro

A few days of weakness to start the year has caught a number of investors by surprise after markets ended 2023 seemingly believing “all was well in the world.” December’s rally buoyed led the S&P 500 to a few hundred points above its 125-day moving average and brought investor sentiment (as reflected by CNN’s Fear and Greed Indicator) to levels of “Extreme Greed.”

While most investors follow and/or are familiar with the broad index that is the S&P 500 and perhaps to those handful of stocks that propelled it in 2023 a deeper look at the market shows both potential risks and opportunities.

While the general index trades around 20x earnings, US Large Growth is over 26x, while Large Value is only around 15x earnings. Such valuations and related expectations could be why they’ve each traded so differently as 2024 kicks off with the S&P 500 down as of Thursday morning (11am pst) over 1.2%, growth stocks down over 2.2%, while value stocks are slightly up by approximately 0.5%.

With higher valuations, come higher expectations and greater probabilities for potential disappointment. This topic was written about by our friends at WisdomTree last month and given the current environment, we thought we should share it with you.

While it’s natural to feel compelled to chase what’s been hot or run from what has struggled the keys to long-term success are in having the discipline to usually do the exact opposite as he’ll explain below.

I hope you enjoy the piece and best wishes for the new year!

Tim and the team at TEN Capital

________________________________________________________

If We See Stock Market Mean Reversion, Heads Will Spin

by Jeff Weniger, CFA WisdomTree 12/6/23

When you do this for a while, there are years that really stick in your head when it comes to the notable and quotable dates of stock market lore. The years 1999 and 2000 are among them, for reasons of the end of the dot-com bubble. Keep those two specific years in mind as we look at four charts.

Right now, the stock market is blowing out the 20 years from 1980 to 2000 on a specific performance metric. The last two decades have witnessed firms with a 0% dividend yield outperforming the highest yielders by a larger amount than at any time in pre-Covid history, including that one. In figure 1, see the boldness with which the snapbacks hit.

Figure 1: 20-Year Rolling Annualized Outperformance, Top Quintile of Stocks by Dividend Yield minus Stocks Paying No Dividends

In figure 2, I divided the Dow Industrials by NIPA corporate profits. Because the market bolted so boldly from the 2009 lows until the height of the mania in 2021, the relationship is near historic extremes. If the chart’s fit is any guide, maybe the coming years witness a market that frustrates the bulls.

Figure 2: Dow Industrials Relative to NIPA Corporate Profits

Another situation that may just mean revert is the relationship between stock and bond returns. If the consensus has it right, that the Fed is done tightening for this cycle, take heed of the message from figure 3. Maybe the hated bond market is ready to start outperforming.

Figure 3: The End of Tightening Cycles Tends to Favor Long-Term Bonds over Stocks

Figure 4 helps that argument. We are at a 20-year extreme in equity outperformance over bonds. Like the chart of dividend payers versus non-payers, the pre-Covid precedent for such things takes place in about the eighth inning of the dot-com bubble: 1999.

Figure 4: 20-Year Annualized Performance Differential, Mega-Caps vs. Bonds

Let’s summarize our four charts:

1. Companies that paid no dividend just had the greatest 20-year bout of outperformance over the biggest dividend payers on record.

2. The Dow relative to NIPA corporate profits points to 2023–2033 being a tough market for stocks.

3. The end of the Fed’s tightening cycles points to bonds beating stocks.

4. 2003–2023 witnessed stocks beating bonds by an order of magnitude that is only matched by the 20 years after the Second World War and by 1979–1999.

We see a lot of portfolios land on our desk. Top-heavy in tech, Magnificent Seven all over the place, huge overweights in U.S. equities, general disdain for fixed income, little or nothing in the way of deep value and on it goes. If any or all of these charts revert to the mean, heads will spin.

DATA, JUST THE DATA

U.S. Jobless Claims – fell by 18,000 to 202,000 in the last week of 2023 which was significantly below market expectations of 216,000 to mark the lowest claim count since October.

U.S. MBA Mortgage Applications – sank by 10.7% on the week ending December 29^th. This marked the fastest weekly decline since February and extended the sharp pivot from the rally in mortgage applications since the start of November.

U.S. Factory Orders – climbed 2.6% MoM in November 2023, recovering from a downwardly revised 3.4% fall in October, and better than market forecasts of a 2.1% increase for November.

U.K. Manufacturing PMI – recorded 46.2 in December 2023. This was slightly below the preliminary estimate of 46.4 and was lower than November’s seven-month high of 47.2. Manufacturing production declined for the tenth consecutive month.

Eurozone Composite PMI – matched November’s 47.6 in December, registering below the 50.0 threshold for a seventh consecutive month, but above earlier estimates of 47. This indicates a sustained but moderate decline in business activity in the Eurozone.