IndexFunds.com Staff

Reversal of the Mean: dogs become stars overnight

Rebounds are rarely as dramatic as the one high-technology sector funds are staging. Hammered worst in 2002, they have bounded back fastest so far in 2003.

"You could say the market has been like a coil in the past 18 months. Companies that were compressed the most in 2002 are now springing back the most so far in 2003," said Sanjay Arya, head of Morningstar Indexes. "The more speculative stocks and sectors - telecom and tech - are leading the recovery in 2003. Many of the stocks that skyrocketed in Q2 2003 were companies that were on the verge of bankruptcy in 2002. Low interest rates helped some of these companies survive, and they've had good performance in 2003."

A surprising negative correlation of -77% exists between last year poor results and this year's shining ones so far for the following high-tech ETFs that comprise the worst performing ETFs in 2002:

source: Morningstar

Why is this happening? A recent study by Merrill Lynch shows that forecast P/E has described 78% of the variation of ETF returns during the first half of 2003.

"The fact that the best performing segments of the market were clearly those with the highest forecast P/E indicates the extent to which the market has been making a strong bet on an across the board increase in future economic growth rather than revaluing individual stocks or sectors based on current results," Merrill's analysts state.

"However, making strong bets on future growth and a willingness to bid up those ETFs trading on the highest (or even negative) forecast P/E's seems quite similar to the market's mode of operation pre-2000," they conclude ominously.

Changes in fortunes of an asset class is often referred to as reversion to the mean, a phenomenon in which deviations from historical growth rates tend to return to the norm. In this year's unusual variation, the market's behavior might be described as reversal of the mean.