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When will the market turn "normal"?

I started reading through an interesting book a month or two ago, called The Little Book of Sideways Markets. It's primarily about how the stock market tends to go through long periods of stagnation followed by long periods of appreciation, then back and forth again. These are the "secular" bull and bear markets that we hear about so frequently.

Two weeks ago, John Mauldin — who wrote the forward — featured a chapter of this book as his "Outside the Box" weekly article (which I get via email). This particular chapter is a good, relatively quick synopsis of why this secular bull/bear pattern recurs. I recommend clicking through and reading the whole thing if you're interested in this topic, as this is a good, short overview of it.

For those who aren't inclined to read the whole thing, let me pick out a single point that I found particularly interesting. Toward the end of the article/chapter, the author is talking about how P/E expansion and contraction is what is responsible for these secular bull and bear markets.

In other words, secular (extended) bull markets occur when investors become willing to pay higher prices for each dollar of company earnings, expanding the P/E ratio. Secular bear markets, in contrast, occur when investors (for a variety of reasons) become less willing to pay up for each dollar of company earnings, causing the P/E ratio to contract. If the P/E ratio didn't change, these "secular" bull and bear market swings wouldn't happen.

In his discussion of expanding and contracting P/E ratios, he deals with the concept of "mean reversion." He argues that this concept is largely misunderstood.

What mean reversion is: the "tendency (direction) of a movement towards the mean."

What mean reversion is not, but what many investors think it is: the tendency for a data item (like P/E) to settle at or around the average for that data series.

He illustrates the huge difference between the two this way:

Although P/Es may settle at the mean, that is not what the concept of mean reversion implies; rather, it suggests tendency (direction) of a movement towards the mean. Add human emotion into the mix and P/Es turn into a pendulum — swinging from one extreme to the other (just as investors' emotions do) while spending very little time in the center. Thus, it is rational to expect that a period of above-average P/Es should be followed by a period of below-average P/Es and vice versa.

Since 1900, the S&P 500 traded on average at about 15 times earnings. But it spent only a quarter of the time between P/Es of 13 and 17 — the "mean zone," two points above and below average. In the majority of cases the market reached its fair valuation only in passing from one irrational extreme to the other.

In other words, there is no "normal" P/E. There is such a thing as an average P/E, but the market doesn't spend much time there. Most of the time, the market is swinging either considerably higher or lower than that long-term average.

This is also true of annual returns, by the way, as we wrote about a couple years ago in No Such Thing As Normal. Everyone seems to know that the stock market's average return has been around 10-11% over many, many years. But the market provides relatively few years when returns are actually close to that average amount.

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