Editor’s note: Regular readers of the Market Minute are familiar with the concept of “reversion to the mean.” Jeff himself is a self-described reversion trader, making short-term trades on overextended market conditions. But that same concept can apply to just about anything in the financial world… on just about any timeframe.

As investing legend and Bonner & Partners chairman Bill Bonner shows today, reversion to the mean is a key pillar of financial wisdom. It’s served him and his readers well over the years. And very soon, he’ll reveal his biggest play on it yet…

On a trip to India a few years ago, the financial press was very eager to hear what I had to say.

They invited me on to their television shows. They interviewed me for magazines and newspapers. The local paper ran a full-page interview and sent out an artist to do a sketch of me.

I thought they might have had me mixed up with someone else. I’m not used to people taking me so seriously.

“Noted Western Economist Gloomy on World Recovery,” was the headline in the paper.

In all these interviews, I had more or less the same message. I told them that the recovery was largely fake, since it was purchased with fake money and depended on fake interest rates.

Stock prices should fall, I said. The property market in the U.S. and Britain would sink further. There would be some spectacular bankruptcies – including some bankruptcies by nations.

The one thing that Indian investors seemed most interested in… and I assume you are interested in, too… was my new “Trade of the Decade.”

But I’m not going to give you a typical investment analysis or a target for GDP growth or for the Dow for this. Instead, I’m going to talk to you about history and philosophy.

I hope that’s OK.

An Out-of-Whack Market

I had great luck with my last Trade of the Decade. Around the turn of the millennium, I recommended selling U.S. stocks and buying gold. It worked out very well on both sides.

[Gold went on to become the best-performing asset class of the decade, soaring over 500%. And when the financial crisis hit between 2007-2009, the Dow plummeted 54%.]

So, people wanted to know what my trade would be for the next decade. I gave it some thought and came up with something. I think this one will work out, too…

But first, let me explain how it works. Behind the Trade of the Decade is a simple observation: things that are out-of-whack tend to get back into whack. Over a 10-year period, you have a fair chance that they’ll return to normal.

This is another way of describing the phenomenon known as reversion to the mean. One of the surest phenomena in the natural world is that things that are extraordinary will eventually become less extraordinary. And over a 10-year period, you have a decent chance that that’s what will happen.

So, what’s my Trade of the Decade for 2010-2020?

At the time I started my second trade, the U.S. Treasury market was out of whack. It had been going up since 1983. Investors were lending money to the world’s biggest debtor at what were historically ultra-low interest rates. And they did this at a time when that debtor is engaged in the biggest borrowing and spending spree in history.

This was not normal. It was downright weird.

I figured that, sometime before 2020, the Treasury market would get whacked hard. So, on one side of the trade… I’m short U.S. Treasurys.

Historically Undervalued

On the other side of the trade, I had more trouble. Because I was looking for something to buy. And nothing was cheap.

Even gold… which I expected to go up much higher… was not cheap. As near as I can tell, an ounce of gold buys about as much – in terms of consumer products – as it did 700 years ago… and maybe even as much as it bought 2,000 years ago.

Gold had already reverted to the mean, after being seriously undervalued in 1999. So, most likely, I figured it would become overvalued when the current monetary system began to break up.

But that’s a different phenomenon. It’s not reversion to the mean; at least not for gold. It’s a reversion to the mean of the monetary system… I’ll get to that in a moment.

What I needed for the buy side of the trade was something that was historically undervalued, which led me to Japanese small-cap stocks, which had been going down since 1989.

So that was the new Trade of the Decade. Sell U.S. Treasurys. Buy Japanese small caps.

But I’m going to give you an even better Trade of the Decade. The problem for non-Japanese investors is that the small caps may go up… but if the yen goes down, you might lose your gains…

An Even Better Trade…

So how about this?

Instead of selling U.S. Treasurys, sell Japanese government bonds. They’re probably even more overvalued than U.S. Treasurys. And with the Japanese borrowing more than ever… as the Japanese savings rate declines… it seems a fair bet that Japanese government debt will go down at least as much as U.S. debt. Maybe more.

By buying Japanese small caps and selling Japanese bonds, you take out the currency risk. You have an even better Trade of the Decade. Even after running higher in 2013 and the first half of 2014, Japanese small-cap stocks are extraordinarily underappreciated. Japanese government debt, on the other hand, is extraordinarily overappreciated.

[The Nikkei Index, a measure of the Japanese stock market, is up 119% since the start of 2010. Japanese government bonds have fallen 1%.]

But the first point I want to make is that this is just an idea. It’s not a substitute for a serious investment strategy.

The second point I want to make is that you can only have a serious investment strategy if you’re willing and able to think deeply about ideas. And if you do think about them enough, you’ll have a decent chance of doing well.

That’s because most people – including most serious investment professionals – don’t think about them very much. That’s what I mean about philosophy: You have to think long and hard about how the world works. And history is about the only tool we have to work with.

Right now, we aim to develop a compass… to help us figure out where we are and where we are going.

On Planet Earth, we can find our direction by reference to the Magnetic North. For investing, we use the most reliable force in finance – the relentless return to “normal” – to get our bearings.

And in searching for normal, we may have stumbled upon what could be the Trade of the Century.

But first…

What Is Normal?

As economists describe it, reversion to the mean is merely a recognition of the tendency for things to stay in a range that we recognize as “normal.”

Trees do not grow 1,000 feet high. People don’t run 100 mph. You don’t get something for nothing.

Normal exists because things tend to follow certain familiar patterns, shapes, and routines.

When people go out in the morning, they know, generally, whether to wear a winter coat or a pair of shorts. The temperature is not 100 degrees one day and zero the next.

Occasionally, of course, odd things happen. And sometimes, things change in a fundamental way. But, usually, when people say “this time is different”… it’s time to bet on normal.

This phenomenon – reversion to the mean – has been thoroughly tested and studied in the investment world. It seems to apply to just about everything – stocks, bonds, strategies, markets, sectors… you name it.

But let’s push on. What is unusual in the chart below? What is so abnormal that the mean is likely to revert against it?

You will note that global debt was only $30 trillion in 1994. Now it is $200 trillion. That $170 trillion in extra credit is probably the whirlwind that sent equities spinning up to the top right.

Those gusts blew stock and other asset prices up to heights never before seen. The Dow reached over 26,000. Houses went on the market for more than $100 million. Gold rose above $1,900.

But while stocks and bonds may have the wind at their backs, it seems to blow in the economy’s face… making forward progress almost impossible. The real economy – at the bottom of the chart – has grown in a rather normal way, but at a slower and slower rate.

Its steady, plodding increase gives no hint of the chaos going on above it. The real economy and the financial world are as different as the eye of a hurricane to the swirling clouds and storms around it.

Another thing you notice is that until the mid-’90s… and again between 2008 and 2012… the average investor got essentially no benefit in exchange for the added risk of putting his money into equities (this chart includes dividends). He might just as well have left his money in U.S. Treasury bonds.

In theory, he is supposed to be able to earn some return – over pure cash – by lending his money to the U.S. government (with the 10-year Treasury bond as the benchmark). He should be able to earn even more, a premium (more than he would earn from risk-free Treasurys), by investing in stocks. The premium is supposed to compensate him for the risk that his stocks could go down at an inconvenient time.

In practice, we find that risk-free Treasurys gave him less than nothing. He has earned less from Treasurys than he would have from gold (which pays zero interest) – over the entire 44-year period.

Stocks, meanwhile, earned him nothing for the first 24 years. Then they exploded to the upside, along with debt, until the financial crisis brought them back in line with gold.

By 2008, the average investor was again earning less on stocks – despite all the risk and bother of market investing – than on gold. It continued like that until 2012, when his stock investments shot up. 

But there is a time to be in stocks and a time to be out of them.  Without knowing the future, you can still know when something is not normal.  And when something is not normal…it is just biding its time, until it becomes normal again.

More to come…


Bill Bonner
Chairman, Bonner & Partners

Editor’s note: Tomorrow morning, Bill will reveal his “Trade of the Century.” Keep an eye on your inbox for it.

And be sure to join Bill at the Legends of Finance Summit this coming Thursday. This event is completely free to Market Minute subscribers, and provides a valuable peek into the minds of some of the world’s smartest, most contrarian financial thinkers. Click here to reserve your spot.