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Why Stocks Will Rise Again

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The bear market has hurt millions of investors. But in the end, is all the pain we're suffering merely payback for the stellar returns of past years? And will investors who stay the course be rewarded for their discipline?

One statistical theory argues that after a long period of strong performance, stocks can't avoid going through a bad period. Known as reversion to the mean, this theory seeks to explain the cycles of rising and falling prices that markets experience.

Paying the piper
In simplest terms, reversion to the mean says that when you compare a market's short-term results to its long-term historical average, you can guess which direction that market is likely to go in the future. After a period of outperformance, for instance, stocks are more likely to fall; after going through a down phase, stocks are more likely to rebound.

This month's brand-new issue of the Motley Fool's Rule Your Retirement newsletter discusses the reversion phenomenon and its impact on your retirement savings. Recently, investors have seen mean reversion play out around the world. Although U.S. markets have fallen sharply after a five-year bull market, international stocks in most foreign countries are down even more, perhaps marking the end of a long run of topping domestic stocks.

Country

Year-To-Date Return

United States

(12.7%)

Japan

(15.2%)

Germany

(21.2%)

India

(36.5%)

China

(52.4%)

Source: The Economist. As of Aug. 28, 2008.

Within sectors, mean reversion has been even more pronounced recently. While commodities stocks have pulled back from record gains, many companies in the financial sector have rebounded from precipitous losses:

Stock

Return, 12/31/07 to 6/30/08

Return, 7/1/08 to 9/3/08

JPMorgan Chase (NYSE: JPM  )

(20.0%)

17.0%

Wells Fargo (NYSE: WFC  )

(19.7%)

32.0%

Fifth Third (Nasdaq: FITB  )

(58.1%)

61.2%

Potash (NYSE: POT  )

59.0%

(32.0%)

Mosaic (NYSE: MOS  )

53.4%

(35.6%)

Freeport McMoRan (NYSE: FCX  )

15.4%

(31.1%)

Petroleo Brasileiro (NYSE: PBR  )

23.2%

(32.2%)

Source: Yahoo! Finance.

Having seen similar cycles in tech stocks and residential real estate, investors now commonly speak about bubbles inflating and bursting -- all as part of reverting to the mean.

Can you profit?
In the October issue of Rule Your Retirement, Foolish retirement expert Robert Brokamp speaks with renowned asset manager and author William Bernstein. When asked whether investors can take advantage of the mean-reversion phenomenon, Bernstein says it's indeed possible -- but, adding some words of caution, he also notes that you won't be right every time.

That advice certainly rings true with many investors. Although few people are surprised when an asset bubble ends, trying to time the end can be incredibly frustrating. As Keynes put it, the market can stay irrational longer than you can stay solvent -- and if you're wrong about when a market will revert to the mean, you can rack up bigger losses than you can handle.

But there's another reason why relying on mean reversion is dangerous. Because averages are necessarily based on historical prices, they can't take shifting economic fundamentals into account. If an industry is dying, the mean-reversion principle won't revive it. And if a particular sector or foreign market is poised for exceptional growth, then it can defy the mean for years -- and make truly amazing profits possible.

In general, though, mean reversion is one of many reasons why maintaining a well-diversified portfolio using asset allocation strategies makes sense. By keeping your money in a variety of investments, you'll help balance out the inevitable ups and downs across your portfolio and keep a more even keel as you move toward your financial goals.

Check out the rest of Robert Brokamp's interview with William Bernstein, along with many more feature articles in this month issue's of Rule Your Retirement. Our retirement newsletter is a premium service, but a free 30-day trial lets you take a look with no obligation.

Fool contributor Dan Caplinger hopes that some of his stocks will revert to the mean soon. He doesn't own shares of the funds and stocks mentioned in this article. Petroleo Brasileiro and JPMorgan Chase are Motley Fool Income Investor recommendations. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is always above average.


Read/Post Comments (2) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 05, 2008, at 10:29 PM, RogerStreit wrote:

    I wholeheartedly agree with your conclusion that “ ... a well-diversified portfolio using asset allocation strategies makes sense. By keeping your money in a variety of investments, you'll help balance out the inevitable ups and downs across your portfolio and keep a more even keel as you move toward your financial goals.”

    However, I do not believe it is useful to invoke mean reversion as a way to explain why we have bear markets. We have periodic bear markets, because we have periodic bear markets.

    Your summary of which countries have done relatively worse so far in 2008 puts things in perspective. But I do not believe you can predict what will happen in the future. Next year, Japanese stocks might do better than U.S. stocks or they might not.

    Also, your comparison of various individual stocks’ performance for the first six months of 2008 and the period 7/1/08 to 9/3/08 is way too short a time period to draw any conclusions. You're leaning towards the Jim Cramer school of market prediction when you measure results in months.

    BTW, I recently wrote about the danger of over-reacting to all of the negative press about a “Bear Market.” www.keyfeeonly.com/blog

    Roger

  • Report this Comment On September 12, 2008, at 1:13 PM, Bhujanga wrote:

    I agree that "Regression" to the mean is not an applicable principle to apply to the state of the market now. There are too many tangible factors to consider. Regression to the mean is a statistical principle that can explain why short term trends may not be significant when they occur in the wake of a statistically significant deviation in the opposite direction, but it is only applicable if it reflects the liklihood that the initial deviation was a result of some random factors. For example.

    Suppose a particular state experiences a couple years where fatal car crashes are way above4 average. Then the next year they start ticketing more speeders and the number of crashes decreases. The Governor might claim the tiketing really did the trick, while in reality it is hard to tell because of the natural 'regression to the mean'. In other ther words, the bad years may have just been anomolous and some improvement was statistically expected.

    However, the stock market is now being affected by many factors that aren't going to just go away, and therefore the possiblity of a long term decline is a real possibility. A big factor is of course the end of cheap oil, which has so many layers of impact. Higher production costs, less disposible income for consumers, etc. Environmental factors are making it more challenging to sustain a healthy global economy. This is driven at the root by overpopulation, which no politicians are willing to even acknowledge, therefore the problem will continue to worsen. These things aren't going away. Tough times are here to stay until something on a a grand scale changes. I don't expect a broad stock market recovery to ever occur. Sectors that can profit from the difficulties that we are facing will be outliers where money can be made, but the days of being able to just be in the market and make money are over, if you ask me, which you didn't, but I threw my 2 cents in anyway.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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