Mean Reversion Made Simple

This paper provides simple context to what are often difficult and highly emotional decisions around money. KCR spent much of 2020 and 2021 producing evidence that the valuations of popular fast growth stocks would lead to their demise. Since the peak in 2021, stock speculation has gone from popular to perilous as mean reversion took its toll.

More recently, our work Tesla Price to Sales Ratio & The Tax on Index Funds and the Vanguard Small Cap Index Fund has shifted readers’ focus to the unprecedented risks in Large Cap Core Funds. KCR’s team believes that the importance of engaging with low-cost process driven active managers has never been higher. As those pieces highlighted, the risk to mean reversion on valuations has created unusually high risks for index fund investors.

The chart below shows the following three pieces of data:

  • First bar: the long-run annual return to the US stock market from 1871 – 2022 is 9.1%[i]
  • Second bar: shows that from 2009 – 2021, the market returned 16.0% per year for 13 years
  • Third bar: shows that in the five years from 2017 – 2021, the market averaged 18.4% per year

The conclusion is clear: this is not sustainable. The market has outperformed historical returns by a wide margin since 2009. Much of this outsized performance came in the 2017 – 2021 period when returns were 2x higher than long-term historical average.

2017 2021 Annual Returns Doubled the Historical Average

YOU ARE NOW READING BASIC MEMBER LEVEL CONTENT

The Mean Reversion Process Can be Unpleasant: Where Do We Go From Here?

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  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.
The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.

  1. Click the following to read more about Definition of Stock Speculation, Avoid Being Enroned, Vanguard Small Cap Index Admiral

[i] The 9.11% annualized rate of return over centuries is sourced from Shiller’s data at Yale and is consistent with academic studies over various horizons.  The variations around this average rate of return are material based on starting valuations, profit margins, and interest rates.  We will touch on our favored valuation metric at the end of this piece and will discuss margins in detail in our upcoming work.

[ii] Hat tip to BB!

[iii] Bloomberg, 06/30/1970 – 01/10/1973

[iv] At a whopping 23 trading days with trillions in government stimulus abrogating the COVID crash and triggering a speculative mania that sent multiple expansion soaring creating a crop of glamour stocks with impossible valuations hardly strikes us as a bear market.

[v] To fall to the long run expected return, the value index would need to fall a mere 15% by year-end.

[vi] We readily acknowledge that the data is murky, but believe that this merely exacerbates the problems of soaring leverage and asset bloat in one of the most crowded and procyclical investments we have seen in our 55 years of combined experience managing money.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

July 8, 2022 |

Categories: Quick Takes

July 8, 2022

Categories: Quick Takes

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