Economics Investing

Mean Reversion

I recently re-read a letter published by the San Francisco Federal Reserve on valuation ratios. Two charts from the report really stood out to me and I believe are worth sharing here.

The first chart (recreated) displays the ratio of household net worth to income historically. Household assets include equity, debt and real estate among others. Of note, this ratio is at an all time high. The paper’s authors state, “Similar to the P/E ratio, this ratio generally tends to revert toward its historical average and does not remain at extreme values, either high or low, for prolonged periods.” Based on historical precedent, we can reasonably conclude that this ratio will likely make a sharp move downward at some point in the future.

The second chart (directly from FRBSF Economic Letter, “Valuation Ratios for Households and Businesses“, January 8, 2018)  displays the asset composition of household net worth historically. Interestingly, it’s clear from the chart that equities drove the spike in the net worth to income ratio in 2000 while real estate drove the ratio higher in the mid 2000’s. Currently, equities, real estate and pension/life insurance reserves have pushed the ratio to its all-time high. Visually, equities appear to be the most the most ripe for a correction, assuming mean reversion, of course!