The Death of Reversion to the Mean for U.S. Equities?

By the Curmudgeon

Introduction:

Vanguard founder John C. Bogle once said that ‘reversion to the mean’ is the stock market’s iron clad rule. That stock prices revert to a mean—articulated by Eugene Fama and Ken French, among others—has long been an accepted premise of investing. However, it doesn’t seem true anymore. We’ll examine why along with some caveats in this article, but first some facts:

l The S&P 500 index up 10.2% this year (through Friday’s close), following gains of 23.31% last year and 24.23% in 2023.

l As we noted in last week’s Curmudgeon post, the S&P’s price-to-book ratio of 5.34 exceeds the 5.05 of 1999, just prior to the dot-com crash.

l Coupled with a S&P trailing price/earnings ratio of nearly 30, a worsening inflation outlook and slowing economic growth (which reduces corporate profits) investors seem to be operating in a “ignorance-is-bliss” mode.

l Reversion to the mean hasn’t occurred since March 2009, when the last major bear market bottomed. Since then, bear markets have lasted only one month in 2020 and 10 months in 2022 vs. the 17-month bear market during the great financial crisis of 2007-2009.

We’ll offer explanations why later in this piece, noting we could be dead wrong, just as Business Week was on August 13, 1979 with their “Death of Equities” cover story.

Editor’s Note: That Business Week article argued that rampant inflation and high interest rates were making stocks unattractive, leading to a decline in individual investors and a shift toward alternative assets like money market funds and real estate. That bearish forecast preceded a massive bull market, with the S&P 500 returning an annualized 17.6% in the 20 years following the article's publication.

U.S. Economy Week in Review:

Last week, the Fed’s preferred inflation measure (core PCE) moved further from their 2% target and consumers grew a bit more pessimistic about the future of the economy and their personal finances. Here’s a fresh look at how the U.S. macro-economic picture is deteriorating:

l The Personal Consumption Expenditures (PCE) price Index, was unchanged at a rate of 2.6% year-over-year. However, the Core PCE, which excludes the volatile food and energy components, rose 2.9% year-over-year, up from 2.8% last month.

l Consumer Sentiment dropped from 61.7 to 58.2 as perceptions of the health of the U.S. economy slipped. Inflation expectations moved up as Consumers remain concerned about rising prices.

l Consumer Confidence slipped 1.3 points to 97.4, and the Future Expectations index declined a similar 1.2 points to 74.8 as it continues to trigger the Conference Board’s “below 80” recession warning signal.

l The Conference Board lowered their 2026 U.S. GDP forecast to 1.3%, which is below the Fed’s already meager 1.6% economic growth projection.

l New Home Sales fell -0.6% in July, down -8.2% from last year. Home Inventory ticked down -0.6% but remains up +7.3% from 2024.

l Pending Home Sales for Existing Homes declined -0.4% in July as they remain near the lowest level on record. With New Home Sales and Pending Home Sales for Existing Homes essentially flat for the month, the housing market continues to be on a shaky foundation.

Mean Expansion Theory:

Michael Green of Simplify Asset Management argues that passive investing—which now accounts for $17.59 trillion, or 53.4%, of all mutual funds and exchange-traded funds, according to Morningstar—tends to make the market continually rise. Equity investors in 401Ks [1.] and other retirement funds exhibit "price-agnostic" or unconditional buying, which distorts valuations and creates a cycle of "mean expansion," rather than “mean reversion.”

Note 1. Approximately 63-65% of total 401(k) assets are in equities (mostly mutual funds), according to data from the Investment Company Institute (ICI).

Historically, rising stock market valuations cause investors to sell shares to lock-in profits and/or reduce risk, but Green argues that the growing dominance of passive funds interferes with this natural mean-reversion process. Let’s dig a little bit deeper:

Passive index funds, such as those tracking the S&P 500, are programmed to buy stocks proportional to their market capitalization. As long as new capital flows into these funds—fueled by 401(k) contributions and other investments—fund managers must purchase the underlying stocks regardless of their price or fundamentals. Because passive funds do not factor in valuation, their constant, flow-driven buying keeps adding demand to the market. This pushes prices and valuations higher over time. When inflows into passive funds are steady, this becomes a continuous upward force driving the stock market higher.

Green argues that investors in passive funds are more likely to hold during downturns and choose to automatically reinvest in their funds, resulting in passive fund managers consistently pouring money into stocks. Given that the S&P 500—the index of choice—is market-cap weighted, more and more money flows into Nvidia, Microsoft, Apple, Alphabet (Google), Amazon and other large cap stocks (e.g. the Magnificent Seven).

Green says this “mean expansion” is the reason the market keeps going up, or at least not down. He believes that mean expansion grossly over-inflates equity valuations, which worries him. “I’ve modeled this stuff out, and unfortunately, all of these models say you end up with a horrific crash,” he warns. That calls to mind the adage that all manias end badly!

Dangers of Passive Investing and Stock Market Concentration:

Felix von Moltke of Oxford and Torsten Sløk, Apollo Global Management’s chief economist, together wrote that “passive investors…have contributed to reduced price elasticity and market responsiveness, which, in turn, have led to amplified price movements, decreased liquidity, potential macroeconomic inefficiencies, and a disproportionate concentration of market influence in a few dominant stocks.” That is surely true now with market concentration in the big tech stocks at an all-time high.

As passive investing grows, fewer investors analyze individual company fundamentals, potentially hindering accurate price discovery and making the market more susceptible to bubbles (like the current AI mania) and momentum-driven price moves.

Also, since index stock funds only sell shares to meet redemptions (which have been few and far between since 2009), the total float of the large cap stocks they own is effectively reduced which decreases liquidity. Green noted that, “Once Vanguard has bought Tesla, do they respond to an earnings report in Tesla? No! That shrinks the effective float in Tesla and raises the volatility of the move in response to an earnings miss.”

As more money flows into passive stock funds, market concentration in a few big names has never been higher. The top 10 stocks in the S&P 500 now make up about 40% of the benchmark index, an all-time high, according to Morningstar data.

"The vast majority of the top 10 are all very likely to move together," Dominic Pappalardo, chief multi-asset strategist at Morningstar Wealth. told Business Insider. "So if you have one or two of those tech names come out with, let's say, weak earnings next quarter, it's likely that all eight of those are going to move downward and sell off simultaneously, which is going to have an outsized impact on the level of that index…..If you go back to a period like April, where we had the post-Liberation Day sell-off, those names also led the market downward."

"There are a lot of things that are lining up to be concerning," Dominic added.

Other Factors at Work:

Excess liquidity, caused by both Fed money printing (keystroke entries) and massive government stimulus (e.g. COVID-19) has prevented recessions (the last one ended in June 2009) and thereby lengthened both the business and market cycles, independent of valuations, fundamentals and the macro-economic environment.

Despite the Fed not lowering rates in 2025, M2 has risen to a new all-time high in the last year:

Conclusions:

With U.S. stock market valuations at ultra extreme historical levels and investors exhibiting speculative bubble-like behavior, it is essential to maintain focus on risk control and not chase stocks higher just because “they’re going up.”

Our esteemed colleague, Lacy Hunt, PhD believes “a significant illiquidity process is emerging” and has warned that the economy is "far worse" than what many on Wall Street believe.

Cartoon:

With investors’ current infatuation with Artificial Intelligence (AI), we close with this cartoon:

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Wishing you good health, success and good luck. Till next time……

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever-changing and arcane world of markets, economies, and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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