At times, changeability is dominant as share prices surge one way or another. Dominant maybe; but not stronger. Over the long haul, mean reversion is the force with the gravitational pull of Jupiter; ready to reclaim hyperactive share prices when they run out of energy.
It could hardly be otherwise if you consider what powers 'changeability'. Clearly a company's share price can change faster than the company itself. Stock market prices are driven only by the need to find a clearing price between buyers and sellers. So prices can instantly go to the level where demand and supply are balanced. When there is as little restraint as that, prices can be driven by the most euphoric buyer or the most depressed seller and flash to correspondingly extreme levels.
Meanwhile, any company, whose shares these bipolar investors trade, trundles along, doing much the same last month, this month and next month. That’s because a company is an evolving collection of assets and liabilities, products and services, debtors and obligations; the workings of which will generate cash for its shareholders. Sure, the amount of cash changes - sometimes dramatically - but it remains far more stable than the company's share price.
And from this cash comes the vital, but elusive, concept called 'intrinsic value' - the value of the uncertain cash flows capitalised at an interest rate that no one knows because it can't be specified. If this sounds vague and conceptual, that’s how it is. Nevertheless, intrinsic value is investment theory's equivalent of dark matter - always there; vital, mysterious and potent.
Meanwhile, stock market values - thanks to the effects of changeability - dart around intrinsic value and it is the job of mean reversion to pull a company's share price back to the sensible level of intrinsic value whenever it flits too far away. It would be nice to be able to say that mean reversion pulls market prices back to reality; except that this particular 'reality' can't be quantified. Even so, that seems a decent way to describe what's likely to happen to equity markets in the coming months. The tendency for mean reversion predicts this perfectly neatly.
Look at it this way: stock market values, as measured by month-end values of London's All-Share index, have risen nine months running since last May. A sequence that long is highly unusual. It is the longest one since the Bearbull Income Portfolio was launched in September 1998 and has produced a 21 per cent rise in the index.
Sure, past results tell us that, at the start of any month, there is a 0.7 probability that the index will end the month higher. Yet in the real world markets are influenced by events and by feed back. So the more that share prices rise, the more that investors fret about the levels to which they have driven them.
For that reason alone, expect a correction soon. And the most vulnerable stock in the Bearbull Income Portfolio is - predictably - the one that has been the most popular: foods processor and engineer Carr's Milling (CRM). In December, with the Carr's price at 1,010p, I tightened the stop-loss parameters on my holding. That meant it would take just a 15 per cent plus or minus move in the share price to prompt me either to sell or to shift the parameters up again. Since then, Carr's has said that it traded well in the first quarter of 2012-13 and the share price has risen another 9 per cent.
At 1,105p, it is rated at almost 11 times forecast earnings, well towards the top end of its long-term range and the shares yield just 2.8 per cent. True, the yield on my purchase price is over 7 per cent, but that’s not relevant. If I sold the holding, or even two thirds of it, I could raise the portfolio's income and reduce its unhealthy exposure to Carr's, which accounts for 20 per cent of invested funds, half as much again as the second biggest holding (GlaxoSmithKline).
With mean reversion likely to do its thing, this looks the sensible course (especially as I’m not due another dividend from Carr's until the end of May). But there is still the small matter of what to do with the cash generated by the disposal.
