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Reversion to mean is a mathematical certainty, but mean is not static

Asia Analytica
Asia Analytica9/2/2021 06:10 PM GMT+08  • 6 min read
Reversion to mean is a mathematical certainty, but mean is not static
Last week’s record close came after the Fed chair allayed fears that current easy liquidity conditions will tighten too quickly.
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Once again, US stocks have demonstrated remarkable resilience. The market bellwether Standard & Poor’s 500 index rebounded from the most recent bout of profit-taking to close at yet another all-time record high last Friday. That is not to say everyone is bullish. In fact, warnings of a major pullback from various quarters — analysts, prominent investors and market commentators — have been brewing for months, pointing to rising risks in high stock valuations, resurgence in Covid-19 cases due to the highly contagious Delta variant, hot inflation driven by logistics and supply chain bottlenecks and the resulting pressure on the US Federal Reserve to raise interest rates, mounting debts and so on. The obvious conclusion is that a correction must be imminent. Or is it?

We have a tendency to expect that markets will always, eventually, follow the path of reversion to mean. Currently, the S&P 500 is trading at 21 times forward earnings, well above the five-year average of 18.2 times and 10-year average of 16.3 times. Thus, a reversion to its historical longer-term averages implies that prices will fall. But such expectations are really driven by emotion. In fact, if you think about it, reversion to mean is a mathematical certainty but mean is not a static number. It is the moving average, and when the market is in a broader longterm uptrend, the mean is also rising.

The US market has surprised many, including seasoned market observers, in how quickly and strongly it recovered from the initial pandemic-driven selloff in March 2020 and, significantly, the absence of a correction (exceeding or even close to 10%) since. The S&P 500 has more than doubled from its pandemic lows — and has set 52 record closes along the way to its 20% gain so far this year.

Clearly, investors are putting money into every dip. Why? Because it is quite simply the most rational investment decision, based on maths. Yes, stocks are not cheap but they still offer better returns than bonds and bank deposits. Forward earnings yield for the S&P 500 stands at 4.7% while dividend yield is 1.3%, which are more attractive than the 1.3% nominal yield on 10-year US Treasury bonds and barely above-zero deposit rates. Are the earnings and dividend yields sustainable? Let us phrase the question another way: Is a recession coming? That appears unlikely in the near to medium term.

Last week’s record close came after Fed chair Jerome Powell allayed fears that current easy liquidity conditions will tighten too quickly. Although he indicated that the central bank might start to gradually pare down its bond purchases (now at US$120 billion [$161.4 billion] a month) before end-2021, that in itself is not a precursor to higher interest rates, which is a separate decision based, primarily, on employment and inflation data.

Extremely loose monetary policies — and the flood of liquidity, which will continue to rise even after the Fed starts slowing its purchases — have been central to the global stock market rally. As we said, all that money needs to be invested. And, right now, based on comparative macroeconomics, the US market is the place to be, for investors of both stocks and bonds. We have previously highlighted the flow of funds from emerging countries into the US markets, which, in the process, are lifting stock and bond prices as well as the US dollar higher.

To briefly recap, the divergence in short-medium term growth prospects between developed and emerging economies have widened over the past few months, with the latter suffering from a resurgence in Covid-19 cases, further delaying their recovery.

By contrast, thanks to the US’ ability to implement massive, “whatever it takes” fiscal and monetary policies to blunt the impact of the pandemic and rapid vaccination rollout, its economy is reopening and recovering far more quickly. Indeed, GDP in 2Q2021 has surpassed the pre-pandemic size and the economy has already recovered three-quarters of the more than 22 million jobs lost at the height of the pandemic in April 2020. Consumers from all income groups are on a spending spree — total consumer spending in 1Q2021 and 2Q2021 have risen well above pre-pandemic levels — bolstered by generous government payouts and a high savings rate.

All this is precisely why our Global Portfolio is currently heavily weighted towards US stocks — indeed, all are US-based companies save for Alibaba Group Holding, Taiwan Semiconductor Manufacturing Co and Singapore Airlines (SIA). Most are global giants but others, such as Builders FirstSource, Home Depot and Servicenow, are very much focused on the domestic market. All derive a significant portion of their earnings from the US.

Corporate America is enjoying exceptionally strong earnings recovery, providing more fuel to the rally. According to FactSet, 2Q2021 earnings growth is estimated at 89.3% y-o-y, with 91% of the S&P 500 companies having reported. And companies are beating market expectations at the highest rate since the data provider started tracking the metric in 2008. Currently, earnings growth is estimated at 41.9% in 2021 and 9.4% in 2022. The S&P 500 companies are also sitting on substantially higher cash levels post-pandemic. Many have resumed their share buyback programmes, which could prove to be yet another source of support for stock prices going forward.

The Global Portfolio gained 1% for the week ended Aug 31. Some of the biggest gainers were Amazon.com (+5.2%), ServiceNow (+3.6%) and Apple (+2.3%). Meanwhile, shares in General Motors Co (-1.4%), SIA (-1.1%) and Bank of America Corp (-0.9%) were the big losers last week. Total Global Portfolio returns since inception rose to 65.1%. This portfolio is outperforming the benchmark MSCI World Net Return Index, which is up 59.3% over the same period.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

Photo: Bloomberg

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