, Editorial director
Reversion to the mean sounds like a nasty phenomenon. The words are almost onomatopoeic. But it doesn't have to be nasty -- it wasn't when stocks recovered from the Great Depression and the returns climbed back toward the historic average.
But given where stock prices are today and what stock market returns have averaged over the past 15 years, the next reversion to the mean, if and when it occurs, probably will be mean.
If long-term returns were to regress to the mean over the next 10 years, investors wouldn't like the annual returns much.
Just how mean would they be? Steve Leuthold, chairman of the Leuthold Group, Minneapolis, has looked at the numbers.
The compound annual rate of return for equities from 1926 to midyear has climbed to 11.5% because of the long, bull market. It was only 9% in the mid-'70s when Ibbotson and Sinquefield published their seminal study.
If that long-term return should regress to, say 11% over the next 10 years, that would imply compound annual returns of only 7.4% over the 10-year period. If the historic return should decline to 10.5% over the next 10 years, that would imply a 10-year compound annual return going forward of 3.5% per year.
Those are mean returns for investors who have experienced double-digit returns for the past 10 years, when the Standard & Poor's 500 stock index has achieved an 18.8% compound annual return.
Looked at another way, what would happen if the price-earnings ratio of the S&P 500 stocks were to return to the median p/e for the 1926-to-date period? According to Leuthold's calculations, the S&P 500 index would decline 60%, to 576. A decline to the median p/e for the 1957-to-date period would drop the S&P 500 by 44%, to 745.
This kind of analysis resents a difficult problem for the many sponsors of 401(k) plans in which employees have high equity commitments. Should they communicate this information to employees? And if so, how?
Most sponsors have tried, in their investment education materials, to let employees know the market does not always go up. But that flies in the face of the investing experience of many younger 401(k) participants who never have experienced a down year in the market.
Perhaps they should be warned in some way that reversion to the mean is inevitable. But how do you do it without bamboozling them with quant talk, or scaring them to death?
After all, some analysts believe that reversion to the mean is not yet in sight, and when it comes it might take far longer than 10 years, which therefore would make it far more benign than Leuthold's analysis would suggest.
One who sees no sign that violent market regression is imminent is Rick Jandrain III, chief investment officer at Banc One Investment Advisors Corp., Columbus, Ohio.
"The country is doing very well economically," he said last week. "It's not fair to assume that the rates of return of the past 10 years will continue in the future. But it's also not fair to assume rates of return in the low single digits."
Mr. Jandrain believes that because of the strong economy, companies will be able to grow earnings at least through next year at a rate strong enough to offset the impact on p/e ratios of the Federal Reserve Board's pre-emptive action against inflation.
Still, now might be a good time for employers to begin warning 401(k) participants that the market is likely to produce significantly lower returns in the next decade than it has in the '90s .