What Goes Up Doesn't Have to Come Down ... Yet

From the hopeless depths of their lows in March, the Dow Jones Industrial Average and the S&P 500 Index have each returned around 60%. For those preferring less drama (and less cherry-picking on my part), the DJIA and the S&P 500 have clawed back a more pedestrian 20% or so year to date.

Media types prefer more drama to less, so they tend to focus on the March lows, insinuating that something has to give when something goes so far so fast. Except nothing has to give: When examining the second half of the 1990s, we can see how impressive gains continued to impress longer than most of us had expected.

The wonder years
In 1995, the S&P 500 appreciated 34%, ending the year with a not-too-disconcerting 18.1 P/E ratio. In 1996, the S&P 500 appreciated another 19%, ending with a still-reasonable 19.1 P/E ratio. Markets thrive on worry, so it was no surprise that worries were percolating after two consecutive years of superior returns, prompting a few stock market prognosticators to predict a down year for 1997.

They were wrong, and embarrassingly so. In 1997, the S&P 500 appreciated another 32% and finished the year sporting an eyebrow-raising 24.4 P/E ratio. Pressure was building. We couldn't rationally expect a fourth consecutive year of single-digit, much less double-digit, appreciation. Time to switch course and short stocks, and stick it to those irrational investors expecting the unsustainable.

But life isn't always so rational: Those irrational long investors stuck it to the short traders in 1998, when the S&P 500 ended the year with a 26% gain and a completely unreasonable 32.6 P/E ratio. The more intransigent shorts were inspired to double down ... and double their losses. The S&P 500 then posted a 20% gain and finished 1999 with a still-unreasonable and still-irrational 30.5 P/E ratio.

So much for rationality. From 1995 through 1999, the S&P 500 more than tripled without posting a losing year. With dividends factored in, the S&P 500 posted only one down year (1990) from 1990 through 1999.

What does mean reversion mean?
How could it be? Surely, the 1990s were an aberration without precedent. Maybe, if we were to exclude the 1950s, when the S&P acted not too differently from the 1990s. The data show that stocks can go up ... and up and up before they go down, a notion that flummoxes many traders and investors, who cite mean reversion to argue that markets must revert to an average performance or valuation level.  

Many investors and traders are misguided in their logic. Mean reversion suggests future returns will be closer to their historical average, but it fails to say that they will be below or above the historical average. Ten flips of a fair coin returning all heads does not necessitate that tosses 11 through 20 be all tails. In fact, it doesn't mean that any of the flips must be tails or heads, at least in the short run.

The long run is another matter: After many flips of a fair coin, heads will equal tails. You could argue that we are experiencing this long-run equaling effect in the S&P 500, if we consider the past 20 years. The S&P 500 is still trading at a 30% discount to its all-time closing high of 1,565, set in October 2007.

But over shorter periods (which can extend for years), we can't expect the universe to align. Just because something has risen dramatically doesn't mean that it's destined to fall dramatically. On the contrary, it can continue to rise, and I believe that scenario is likely for the following five stocks that have risen dramatically. 

Where's the logic?
These stocks were hit particularly hard during the 2008 financial crisis, so they are still significantly discounted from their all-time highs. Obviously, that reasoning alone doesn't justify a purchase. After all, a lot of companies were hit hard, and just because a stock has traded at a high price in the past doesn't mean it's destined to trade there again. Just ask any long-suffering Cisco Systems (NASDAQ:CSCO) or JDS Uniphase (NASDAQ:JDSU) investor.

That said, companies can and do go back to where they've been, particularly cyclical companies -- those whose futures are tethered tightly to the macroeconomy. It's fair to say these five companies are tethered tighter than most, which bodes well for investors. Sure, these companies have flipped an impressive string of heads this year, but that doesn't mean the string is destined to end any time soon. After all, shorter periods can last a remarkably long time.