Banks and value take lead as markets go through long-awaited 'mean reversion' trade to start 2022

Published Tue, Jan 11 20226:30 AM EST

Mean reversion? What was in last year is out this year and what was out, is in. Thanks in part to the Federal Reserve, many market participants expect stocks in 2022 to exhibit a long-awaited mean reversion. Mean reversion is a theory that suggests that asset prices will eventually revert to their long-term mean (or average) levels. For example, the average yearly return on the S & P 500 since 1926 has been roughly 10% a year, but the S & P's average yearly return since 2009 (when the Fed began injecting large amounts of liquidity into the economy to combat the Great Financial Crisis) has been close to 15% a year. If mean reversion is valid, it would suggest that the S & P is likely in for a series of sub-average (i.e. below 10%) returns for the next few years. It also suggests that some sectors, such as technology, which have had outsized returns in the last decade, but particularly the last few years, will also underperform. That appears to be the case, at least for the start of 2022. What's old is new Last year, technology was a dominant sector, up 34%. This year, tech is the laggard by far, down 5%. In 2021, Real Estate Investment Trusts (REITs), while far smaller than technology, were also a top performer, up 37%. This year the group is among the worst performers, down 6%. While banks lagged for most of last year and only began to rally in the last two weeks of 2021, they are among the market leaders in 2022, up 9%. Despite a late-year surge in value stocks (energy, industrials, pharmaceuticals), growth stocks (mostly technology) again outperformed value in 2021, up 31% vs. 22%. This year, however growth is down 4%, value is up 1%. International markets, for the most part, have underperformed U.S. stocks for many years. However, with the S & P down 2% in 2022, most international markets are outperforming. Hong Kong, mainland China, Taiwan, and the UK are all positive, while most of Europe, while down, is still outperforming the U.S. What's behind mean reversion? Nothing grows to the sky forever. There are natural limits on how much a company, or a sector, can keep growing. That simple concept is a powerful mental tool for many on Wall Street. Take the persistent outperformance of growth stocks over value in the last decade but particularly in the last five years or so. Growth valuations have run well ahead of 10-year averages, according to Scott Chronert at Citigroup. Not so for value: large cap value stocks are trading only in-line with historic averages, while small- and mid-cap value stocks carry valuation well below the 10-year trend. This would imply small and mid-cap value stocks should outperform at some point. Still, mean reversion doesn't necessarily occur in a vacuum. Chronert notes that various valuation metrics like return on equity have been trending higher for those small- and mid-cap stocks. This, Chronert says is, "implying a performance mean reversion this year relative to last year's lagging returns, and relative outperformance opportunity." The lessons of mean reversion For long-term investors, there is a lesson: mean reversion is a characteristic of markets that is hard to ignore. For example, Vanguard, in its 2022 Economic and Market Outlook, noted that "The removal of policy support poses a new challenge for policymakers and a new risk to financial markets." Vanguard described its long-term outlook for equities as "guarded," noting that "high valuations and lower economic growth rates mean we expect lower returns over the next decade." How much lower? They expect returns on a 60/40 stock/bond portfolio to be roughly half of what investors realized over the last decade (from 9% to approximately 4%). Mean reversion is very much evident in their forecasts. On international vs. U.S. stocks: "We believe that there is a high probability that international equities will outperform U.S. equities in the coming decades." Vanguard also expects mean reversion in value stocks, which they expect to outperform because their competition (growth stocks) will see a decay in their valuation, not necessarily because value stocks will return to their historic normal returns. Finally, Vanguard cautions investors against swallowing one of the oldest fallacies in the book, a behavioral quirk that has come to the known as the "Gambler's Fallacy": the belief that just because something has happened in the past (abnormally high stock market returns for several years), it is supposed to keep happening in the future: "Our confidence in our low-return outlook has only grown stronger, and we continue to caution investors against extrapolating future results from the past."

Traders on the floor of the NYSE, Jan. 10, 2022.

Source: NYSE

Mean reversion? What was in last year is out this year and what was out, is in.