Brace for Reversion to the Mean

It seems that just about everything in the universe is mean-reverting. I don't care whether it's the average annual snowfall in Buffalo, the number of monthly speeding tickets issued on I-495 or P/E ratios, one way or another mean reversion will have its way.

According to my Value Line Publishing chart, the long-term average P/E ratio on the Dow is 14.5. However, 16 times in the last 88 years the ratio has sunk below 10. Below 12, the frequency increases by another 11 events -- that's a significant 31% of the time we see below-trend P/Es. But investors haven't experienced such a low ratio since 1988. It's going to happen again, it's just a question of when. Given the depth of the financial crisis and the as-yet-unknown depth of the consumer-led global recession, it's not unreasonable to think that we may soon revisit the ugly side of mean reversion.

The P/E on the Dow is currently incalculable due to negative earnings for the group, so let's work with the S&P for the moment. Barron's calculates that the S&P is trading at 17.1 times trailing earnings. As for next year, it's folly to predict where earnings will come in, but for the sake of discussion, if you're of the bearish persuasion, let us say earnings decline to between $50 and $60. If you want to find a silver lining, $75 to $85 is reasonable. Apply a 10 multiple to any of those outcomes and it takes you south of the current 975 S&P valuation, and perhaps considerably so.

So if we believe that everything ultimately reverts to the mean, we have some choices to make:

1. we can hope -- never a good idea for investors -- that Washington understands mean reversion and will do something to change the dynamics that affect the trend line, or
2. we can consider altering our investment strategy.

Let's examine both choices.

Don't hold your breath, but here's an idea that players in Washington could pursue if they wanted to alter the valuation trend line of stocks.

Stockowners are not being justly compensated for the risks they take. Adjusted for inflation and dividends, the S&P and therefore most investors have suffered losses on the order of 15% to 20% over the last decade. To make matters worse, dividends -- which have been the only buffer to the ravages of inflation and capital loss -- are double-taxed. Of course that's unjust, but it's also not providing the proper incentive to be a long-term owner of stocks.

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At the time of publication, Masino was long ICO, but positions can change at any time.

Rich Masino is president of Private Investor Research and editor of The Substantial Investor. He is a private investor who manages a family long/short investment portfolio that holds numerous positions across a variety of asset classes.

Before starting Private Investor Research, Mr. Masino co-founded a telecommunications company that grew to 500,000 customers. He sold all of his interests in the company in 1998.

He holds an MBA in finance from St. John's University.