5 - The crash of 2000–2002 and imminent rebound

Abstract

Well-accepted economic theory and evidence documents mean reversion in business profits over time. At the same time, the efficient market hypothesis posits that this predictable reversion to the mean in business profits holds no importance for investors. In a perfectly efficient market, all relevant information, including trends in business profits, are fully incorporated in stock prices. Both short- and long-run rates of return in a perfectly efficient stock market follow a random walk. From an efficient markets perspective, any perceived tendency for mean reversion in stock market returns can be dismissed as a simple manifestation of the well-known regression to the mean concept from the field of statistics. Nobody can predict when the market will take a protracted severe drop. However, after the market has taken such a drop, the overreaction hypothesis suggests that forward-looking returns will be above average. In response to a protracted severe drop in the overall market, such as the crash of 2000–02, the overreaction hypothesis suggests that prudent investments should adopt a fully invested and diversified position in stocks. While backward-looking investors remain shell-shocked by the historic 2000–02 crash on the Nasdaq, forward-looking tech stock investors will benefit greatly from the ensuing recovery.