Mid-Year Update – Reversion to the Mean

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Reversion to the mean is a fancy statistical term for the tendency of data points to return to their historical average over longer periods of time.  As an example, according to Google, the average June rainfall in Pittsburgh is just over four inches for the month.  Could be zero, could be eight inches, but you would expect over time for it to be close to four inches, reverting to the mean.  In one of our Investment Committee meetings recently, one of our newer associates, Ben, asked a great question.  He said, “All the academic data tell us small-cap stocks outperform large-cap stocks, but they have not for years.  Why is that?”  Before I get to the answer I shared with him, let me give you just a little more data.  According to Dimensional Advisors, since 1927, small-cap stocks have averaged 13.1% a year and large-cap stocks have averaged 10.1% a year.  This would make sense in a simple risk/return analysis.  Typically, an investor demands a higher return for taking a higher level of risk.  For instance, you get 2% from your savings account because they are safe.  Since small companies are perceived as riskier than large, established companies, the three percent higher return for small-cap stocks seems logical.  However, in the recent past, small-cap stocks have been trounced by large-cap stocks.  According to The Wall Street Journal (WSJ), over the past three years, large-cap stocks have averaged 8.4%, while small-cap stocks have averaged -1.9%.  Why?

One of my favorite stock market quotes, attributed to Warren Buffet, is “in the short term, the stock market is a voting machine; in the long term, it is a weighing machine.”  That means when a new sensation grabs investors’ attention, they “vote” with their money, piling into the trend in the short term.  Today, that new sensation is AI, or artificial intelligence.  In the late 1990s, it was the internet.  Before that, we have seen oil stocks, banks, the nifty 50 and even tulip bulbs grab investors’ attention.  Over the longer term, shareholders invest based on long-term growth expectations, and the weighing machine will determine a fair price.  The AI investment boom has fueled companies like the “magnificent seven” to very high stock valuations versus traditional measures.  These companies have tremendous earnings and are growing nicely, but they will not lead forever, and their growth will not be non-stop.  Eventually this fad will cool.  Stock returns overall will revert to the mean, we just do not know when.  That will be a combination of hot stocks cooling and cold stocks getting warmer as investors look for value elsewhere.  My experience over forty years in the industry has taught me that just when I feel like throwing in the towel on the broad market and buying into the current sensation, things are close to changing.

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The most recent quarter (past ninety days) demonstrates how the divergence in performance has widened, even with large-cap stocks.  Again, from the WSJ, “The pattern of divergence shows up in sector performance, too.  Tech led the way in the second quarter, followed by previously oversold telecoms and media companies—grouped as communication services.  Utilities, which have become an AI play because of expectations that new data centers will stroke electricity demand, also did well.  But six out of eleven sectors—healthcare, real estate, financial, energy, industrials and materials—lost market value.”  This is where I add emphasis.  Six out of the eleven sectors in the S&P 500 lost money last quarter while the index went up on the back of AI!  I do not think Americans quit banking, quit going to the doctor, quit paying their rent or mortgage or quit driving cars or using air conditioning, etc., over the last ninety days.  It is just that in the past ninety-day “voting period,” those companies were deemed boring or too old-fashioned versus the hot new alternative of AI.  Over the longer-term “weighing period,” the market will find a value for all the sectors of the S&P 500 that is proportional to their contribution to the growth of the economy.  The winner-takes-all mentality (whoever the current winner is) has never lasted in the dynamic financial markets of the United States for extended periods of time.

Statistically, it has been a great start to the year.  The S&P 500 is up 14.5% for the first six months of the year.  However, as I have pointed out, it has been dominated by the outsized winners in technology stocks.  A diversified portfolio of stocks and bonds that includes mid-cap, small-cap and international stocks along with a mix of quality bonds has performed very differently.  We customize portfolios for each client based on their needs, objectives and risk tolerance.  That makes it difficult to give an “average return” since each client has their own unique mix of stocks and bonds.  Using two different indexes for the classic 60% stock, 40% bond mix, one from Vanguard and the other from Blackrock, a diversified portfolio has returned around 8.8-8.9% for the past six months.  That is well shy of the S&P 500 return, but it is a very good return by historical standards.  I do not think the financial markets need to go down after this great start.  I am not even sure the presidential election will have a significant impact on the financial markets.  I do think that as the bull run in stocks gets extended, smart investors will be looking to invest their money wisely, looking for bargains and stocks that are not at all-time highs.  The stock market will eventually revert to the mean.  Large-cap stocks will slow down, and small-cap stocks will pick up.  As the Fed cuts rates (eventually), bonds will perform better.  The diversified portfolio will be the way to go in the long term as investors weigh all their investment options.  I hope you all had a great 4th of July and enjoy the rest of your summer.

Mike Kauffelt
Co-CIO, Bill Few Associates, Inc.

Data Source: The Wall Street Journal

Contact Michael K. Kauffelt, II, CFA

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