- A large body of literature holds that the equity market premium is countercyclical and, using valuation ratios, is predictable.
- The investor return gap persists, despite strong evidence that factor performance is mean reverting, because investors use the manager selection process for alpha timing.
- Contrarian strategies enable stalwart investors to overcome the institutionalized behavioral biases that depress long-term returns.
Substantial evidence supports factor return predictability, yet evidence also indicates that investors are not reaping, to the greatest extent possible, the excess returns commensurate with such knowledge. A significant contributing factor to suboptimal investment results is the institutionalization of individual investor behavioral biases related to the confusion of short-term performance and manager skill as well as misplaced blame for poor outcomes. The good news for individual investors is—being free to act outside of institutional decision-making processes—they are more apt to make decisions that allow them to benefit from long-term mean reversion in factor returns.
Are Factor Premiums Mean Reverting?
Increasingly, researchers are finding evidence that factor performance is mean reverting. A large body of literature argues that the equity market premium is countercyclical and predictable, using valuation ratios. The empirical literature shows that dividend yield and CAPE (cyclically adjusted PE) can predict future equity market returns.1 Put simply, when the equity market rallies for an extended period of time, its CAPE ratio becomes meaningfully higher than the historical average. A common interpretation of a high CAPE is that the market is expensive. When a high CAPE mean reverts toward the historical norm, the resulting forward return for the equity market falls meaningfully below average.2
Evidence is also mounting that other factor premia, such as value and low beta, are also time varying and predictable.3 Table 1 reports for a number of popular factors the one-year-ahead predictive regression using the valuation spread as the predictive variable. The t-stat and the R2 support the claim of predictability based on mean reversion. For example, when value stocks are substantially cheaper than growth stocks—meaning the spreads in valuation ratios are abnormally wide—a reversion toward the norm would result in above-average value stock outperformance.
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These empirical observations have obvious implications for investors allocating to factor exposures and the smart beta products that house them. It suggests that successful market timing could be possible! First, however, it is useful to understand the source of this return predictability. As it turns out, timing is possible, in part, because most of us time very poorly, and there are attributes, baked into our institutions, which ensure we will continue to time poorly!