Following on from last month`s missive on financial bubbles we will explore the theory that is mean reversion. Mean reversion? No, it`s nothing to do with a fiscally careful man trying to drive his car backwards but rather a concept that analysts use to consider future pricing trends. With that poor attempt at humour out the way let`s get on with the show. In summary mean reversion is a theory that suggests that prices and levels of return eventually move back towards the mean or average. The concept can be applied to various prices or values including equity indices, commodity prices or economic growth rates. It is often used in terms of investment. Long term price trends can be gauged by a trend line or moving average. Given a long enough time-frame then the current price of a stock or commodity can be judged against its long-term average. If it is significantly higher than the historical average then investors can expect a fall or at the very least a period of consolidation. The theory seems to work best with generalized conditions such as an equity index or a property index. An individual company can sign a major contract that literally changes the fortunes of the business. The price shoots up and the average plays catch up. It is unlikely that the share price will fall to previous levels but a period of price consolidation will eventually see the moving average close in on the actual stock price. There are two ways of applying the concept. We can either take a time-frame and just calculate the average, draw a line and pronounce judgement from there or we can use the fluidity of the market to consider price trends by calculating a moving average. The shorter the period of time used to calculate the moving average the closer to the actual price of the market it will be. First, let us consider mean reversion in its purest form. The chart below shows the historic P/E ratio of the S&P Composite since 1880. The average P/E is around 15. On this basis with the current P/E of around 20 share prices could be considered over-priced. Notice that almost any move that crosses the mean leads to a significant continuance of the move. Despite the huge rise in P/E`s during the dotcom bubble and a significant retracement the ratio is still high and with the current economic climate we should anticipate the ratio to drop which would mean equity prices become cheaper. Bulls will argue that the average P/E of the last ten years has been much higher than that of the last century and therefore current prices are cheap but the wise birds will remind us that things are never different and despite a prolonged period of inflated value the bubble always pops in the end. If we use moving averages as a shorter term indicator we may still identify likely future trends. Rather than use P/E ratios we can use actual share prices. Take a look at the S&P500 chart below. It shows the index`s performance over last ten years: Notice how the market trades one side of its mean for many years but when it finally breaks through it heralds a major reversal in fortunes. The change of direction is confirmed as a new trend by the significant move made through the average. Believers in the theory would suggest that the failure of the market to rally above the average earlier this year when it challenged the 1400 mark is a sign that the down trend is confirmed. Add in the current economic woes and it appears that US equities are still highly overpriced. As the chart illustrates on the price action will break through the moving average and continue on in a reversal of the previous trend. These types of movement can indicate an over-bought or over-sold situation. Highly over-priced or under-priced assets are usually a sign that human emotion has taken over from logic. Despair in a bear market and delusion in a bull market. Many market analysts use similar types of averages and calculations to try to forecast future market movements. These types of studies are known collectively as technical analysis. Not a topic for today but an interesting subject nonetheless. So what conclusions can be drawn? Certainly equity and property prices are still too high. Add in the likelihood of the trend continuing into the over-sold zone it is not too much of a stretch in the imagination to foresee a further decline of 30% in equity prices and 50% in property. The economic conditions are woeful with the credit crisis likely to continue for a few years to come. The theory of mean reversion is underpinning prognosis.