By Ernst Knacke, head of research at Shard Capital
Humans love mean reversion because it feels comforting. It implies that extremes correct themselves and time pulls everything back to normal. That’s because change is uncertain, and with uncertainty comes fear.
That’s the same for investors. Mean reversion is not only a driver of returns, but it is often used as a tool to manage risk. Overvalued implies downside risk and undervalued implies upside potential. Ultimately this is comforting as we expect valuations normalise as things are pulled into equilibrium.
But markets are not governed by comfort. And not everything ‘mean’ reverts.
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Government debt is the obvious example. For decades, investors have assumed fiscal excess would eventually be corrected by discipline, austerity, or political common sense. Yet the opposite has happened.
As the dark blue line in the chart below highlights below, debt levels have simply kept rising, as each cycle demands more borrowing, more intervention, and more monetary accommodation. The same is true for fiat money itself. Paper currencies do not mean revert in value over the long run; they decay, as indicated by the gold line. Which helps explain why assets priced in fiat money can appear to do the opposite.
A key question for investors is what will happen to the turquoise line: corporate profit margins?
Traditional theory says competition should erode excess returns. Schumpeter’s capitalism, however, is not a tidy world of equilibrium. It is a brutal process of creative destruction in which one winner increasingly takes all. The reality is capitalism naturally breeds inequality, because scale, technology and capital tend to concentrate in the hands of the few. And over time few will continue to become fewer. Perhaps that is why – much to the delight of growth investors – US corporate profit margins have remained so resilient for so long,
Now enter AI. If the optimists such as Elon Musk and Cathie Wood are even broadly right, we may be on the verge of a step-change in productivity and output unlike anything seen in decades. If so, much of the equity market may still be materially undervalued. But here lies the catch: the same force that creates extraordinary winners may also render countless businesses worthless. AI could expand margins at the index level while destroying them company by company.
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This is why investing is hard. Mathematics may imply there is always one correct multiple, one fair P/E. But that fair value depends on a future nobody knows. Human emotion, narrative and behavioural bias ensure prices will always deviate from that supposed truth.
The real task for the allocators of capital is not to assume mean reversion. It is to understand what mean reverts – and what never will.
The below chart shows the US dollar has lost over 96% of its purchasing power due to inflation since 1933, while US debt ballooned from $22bn to $37trn over the 92 years. Corporate profit margins, highlighted by the turquoise line, has also been trending in one direction for over three decades. Will AI bring this trend to an end, or ensure the next leg up?
