VALUATIONS REVERT TO THE MEAN, BUT THE MEAN IS ALWAYS A MOVING TARGET

In investing, mean reversion is the idea that asset valuation ratios tend to move towards their historical averages over time.

- MANUJ JAIN

It helps investors spot opportunities by showing whether assets are cheap or expensive versus long-term norms.

Key ratios like the price-to-earnings (P/E), price-to-book (P/B), and bond-equity earnings yield ratio (BEER)—which compares bond yields with stock market earnings yields—indicate valuation levels. Ratios above the long-term mean may signal downside risk, while those below suggest potential upside.

However, the mean itself shifts with economic cycles and structural changes. Relying solely on past averages without context can mislead investors and result in poor decisions.

Economic cycles are neither uniform nor brief; they often last for years, sometimes even decades. These cycles take many forms—stagflation, recession, economic slowdown, disinflationary or inflationary growth, healthy expansion, booming markets, and overheated bubbles. Each phase has its own drivers such as corporate earnings trends, liquidity conditions, investor psychology, risk premiums, and broader macroeconomic forces.

Assuming that the average valuation of the market during one economic phase can be carried forward unchanged into another ignores these dynamic realities. Investors who fail to consider this risk and base their decisions on outdated benchmarks may either miss opportunities or take on unnecessary risk.