Why The Market is Ripe for a MAJOR Shift

PIMCO CEO and all-round market egghead Mohamed El-Erian coined the term "The new normal" during the financial crisis of 2008.

El-Erian's new normal is defined by slow economic growth, persistent unemployment and an accommodative fiscal policy from global central banks and volatile markets.

This new normal results in meager bond yields of only 2% and a tepid return from equity investments. Up close, this seems like an accurate description of today's economy. But if you step back and look at the bigger picture, then maybe the new normal is just becoming the "old normal" again.

Reversion to the mean

In statistics, "reversion" or "regression toward the mean" occurs if a variable is extreme on its first measurement, then it gets closer to the average on a second measurement. If this variable is extreme on a second measurement, then it tends to have been closer to the average on the first measurement.

So how does this relate to the stock market?

In a nutshell, if you believe in a reversion to the mean, then eventually, the markets will return to their long-term averages or behave more like they have during a longer period of time. El-Erian's new normal comes off of the heels of a two-decade-long period of extreme variables on the upside and downside of financial markets.

Take a look at this chart...

As I've said before, charts are not my specialty, but the emerging historical significance of the data shown here can't be ignored. As tepid as things are, it's possible we're returning to the good ol' days.

During the 1990s, we experienced a bull market fueled by tech stocks that spilled over into other sectors. Large pharmaceuticals traded with price-to-earnings (P/E) ratios of more than 30 based on excessive optimism over new wonder drugs and demographic trends. Today, many of those same stocks trade in more modest territory, with P/E ratios of 12-14.

Back in the day, regional banks in the United States consolidated paying 2.5-3 times book value for one another. But now? While consolidation needs to continue for the health of the marketplace, it's nowhere close to the pace we saw coming into the 21st century. Many of the largest players in the regional bank space now trade at deep discounts to their tangible book value. Some of the stocks still languish in single-digit territory.

So, if the 1990s seemed like an age of extreme optimism, then the first decade of the 2000s was definitely the opposite. Again, the chart above says it all.

So after a 20-year roller coaster ride, are we finally moving somewhere in the middle as far as the market is concerned? Maybe.

Gold vs. stocks

In researching the reversion to the mean, I decided to chart the relationship between stocks and gold.

Using an inverse chart, I included the beginning of the century, when it felt like the entire world was coming to an end.

You can clearly see when the equity markets became extremely jittery at the beginning and the price of gold started climbing. The most glaring picture is the growing fear in 2008 (Lehman Brothers failure), when gold bulls became super-bulls and the masses gave up on what we've come to know as common stocks.

Now, let's focus on recent history. Here's another chart of the same asset classes using a compressed time period.

The discrepancy between the two has become a little tighter.

Clearly, stocks are still not setting the woods on fire. But at the same time, it does appear they've picked up some confidence and that gold is starting its long process of rolling over. Gold is a classic fear asset. Its return to medium-term price weakness is an indication of fear dissipating, which is always good for stocks.

It's a volume-based business

Another indicator of abnormal market conditions, naturally, is trading volume.

This chart shows a 12-year study of the average weekly total volume for the New York Stock Exchange.

It appears that as we entered the decade, equity trading volume started falling below the higher volume we had experienced for the previous 12 years.

So what does this mean?

For one, it means less market participation by the masses (Remember the old trader's axiom of "getting out" when you start getting your stock tips from shoeshine boys?). Although equity mutual fund inflows have increased recently, they're still down from levels seen at the turn of the century.

Another assumption is there's less knee-jerk buying or selling out of panic. A "wait-and-see" approach is more the style of today's investors. They pay attention to figures like valuations and earnings. In the long run, this is a very good sign for stocks.

Risks to Consider: Does this mean that markets have returned to a golden nirvana? Hardly. Europe is still a mess. The United States is facing a debt crisis and global economic growth is slow. But the trend is improving and the trend can be your friend. Caution is still advised, but the best way to be cautious is to research and select quality.

Action to Take -- As markets adjust to more normal and rational patterns, the best route for investors to take should be high-quality, blue-chip stocks with consistent histories of growing their business during improving economic climates, while managing their businesses in a defensive manner.

A few stocks to consider would be health care giant Johnson Johnson (NYSE: JNJ), which trades with a forward P/E of 14 and yields about 3%, ConocoPhillips (NYSE: COP) with a bargain basement forward P/E of about 10 and a yield of more than 4.5%. And finally, Microsoft (Nasdaq: MSFT) with a forward P/E of roughly 9 and a yield of roughly 3.5%. These companies consistently perform over time, reward their investors with dividends and are poised to benefit to a return to the real normal.

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Adam Fischbaum brings more than 15 years of professional investment experience as financial advisor and portfolio manager.