Stock market: the return to the mean

GUEST BLOG. When the markets have been appreciating for a long time, more and more people are inexorably drawn to them. However, the stock markets have definitely recorded strong growth since the 2008-2009 financial crisis. There have been a few episodes of corrections, including the sharp drop in the spring of 2020 due to the COVID-19 pandemic, but the stock market performance of North American indices has been extraordinary.

As proof, since its low reached in February 2009, the flagship American index, the S&P 500 Total, which takes dividends into account, has recorded an annual compound return of 18.58%! This is a far greater return than the nearly 10.0% compound annual rate of return it has recorded over the past 100 years or so.

In his book La Bourse ou La Vie, my father wrote: “Trees do not go up to the sky; the purse is made of the same wood“. To me, this quote means at least two things:

1. You should not extrapolate the recent performance of an index or a company, whether positive or negative;
2. Most natural phenomena will sooner or later return to their long-term average.

Remember that an annual compound return of 18.58% means you double your capital value in less than four years, using the rule of 72 *. Also remember that Warren Buffett, probably the best investor of modern times, has achieved an exceptional annual return of almost 20% over a period of more than 50 years. Do you really believe that the S&P 500 can sustain compound annual growth of over 18% for several more years?

Many natural phenomena are dictated by what we might call “the mean reversion”. On the stock market, you will observe it constantly: the stock which posted the best stock market performance last year may very well have a poor year next year and vice versa. A company’s very high profit margins will attract competition, which will put downward pressure on those same margins. The sector that is the subject of strong investor enthusiasm for a while will inevitably lose its appeal over time.

This is why I believe that an investor should be careful with the exceptional stock returns of the last few years. On the one hand, he should be grateful and congratulate himself for having happily participated in it. But on the other hand, he should remember that the returns of the past 12 years have been nothing short of exceptional and they certainly cannot continue indefinitely.

After several years of exceptional returns and assuming that future stock returns will approach the long-term historical average of almost 10% per year, it will necessarily be necessary for future returns to be less than 10% in the years to come. . At least that is what the phenomenon of the return of the mean teaches us.

This is why I believe that an investor should remain cautious about the stock markets, stick to quality securities at a good price, diversify his portfolio well and avoid the use of margin or options strategies. . This is also why it should make conservative projections of returns for the years to come.

I would add that while stock returns for the next several years are likely to be lower than the historical average, they will likely be significantly higher than most other investment options.

* The rule of 72 is one way to calculate the number of years it will take to double your savings. All you need to do is divide the number 72 by the percentage return you expect to get. The result tells you the approximate number of years it takes for the value of your money to double.

Philippe Le Blanc, CFA, MBA

Chief Investment Officer, COTE 100