Mean-reverting valuation ratios such as the price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, or bond-equity earnings yield ratio (BEER)—which compares a government bond’s yield to a stock market’s earnings yield—can help investors gauge whether an asset class is cheap or expensive compared to its historical average. If a ratio is significantly above its long-term average, it suggests that valuations may eventually decrease, while values below the mean indicate potential upside.

While mean-reversion is a well-established concept, a critical nuance is often overlooked: the mean itself is not a fixed number. It is a moving target, influenced by economic cycles and changes to the structure of an economy. Simply relying on historical averages without understanding the broader economic context can lead to misleading conclusions and sub-optimal investment decisions.

Don’t ignore the macro

Economic cycles are neither uniform nor brief; they often span years, and sometimes even decades. These cycles take several forms including stagflation, recession, economic slowdown, disinflationary or inflationary growth, healthy expansion, booming markets, and overheated bubbles. Each cycle has its own drivers – corporate earnings trends, liquidity conditions, investor psychology, risk premiums, and macroeconomic forces.

Assuming that the average valuation of a stock during one economic phase can be carried forward unchanged into another ignores these dynamic realities. Investors who fail to consider this risk and base decisions on outdated benchmarks may either miss opportunities or expose themselves to unnecessary risk.

Consider a booming economy as an example. During such periods, corporate earnings often see robust growth, credit is easily available, risk appetite is high, and investor sentiment is broadly optimistic. In such an environment, markets frequently trade above what would have been considered ‘fair value’ in a more subdued phase. Valuation ranges shift upward, and prices hover between fair value and fair-value-plus. Investors who wait for markets to revert to ‘cheap’ historical valuations may remain underinvested for years, missing valuable compounding opportunities.

In such scenarios, the market is unlikely to drop down to distressed or bargain valuations unless an extraordinarily rare, severe shock—a black swan event—occurs. Examples of such events include the global financial crisis of 2008 and the covid pandemic.

Conversely, during recessions or periods of stagflation, the mean valuation often falls. Earnings visibility becomes limited, risk-aversion rises, and required equity risk premiums expand. Valuations that may have appeared ‘normal’ in growth phases may now be too high, reflecting increased uncertainty. The market’s fair zone compresses, and what seemed cheap in such a cycle may actually be a fair reflection of the prevailing risks. Recognising this dynamic nature of the mean is crucial for investors who wish to make informed decisions across market cycles.

Adapting one’s valuation framework to the prevailing macroeconomic context allows for more informed investment decisions. A P/E ratio of 18, for instance, might be considered expensive in a slow-growth, high-interest-rate environment, but fair or even attractive during periods of strong growth and abundant liquidity. Similarly, a high P/B ratio may not always indicate overvaluation if supported by a robust return on equity (ROE) and strong earnings growth. Context is everything.

Ratios: the more the merrier

Another important point for investors is that no single valuation metric can tell the whole story. Individual ratios are useful, but they are most effective when used together. Each ratio provides a unique lens, and combining multiple indicators offers a comprehensive perspective.

For instance, overlaying P/B ratio analysis with ROE can reveal potential undervaluation that the P/B ratio alone may miss. Likewise, when assessing whether equities are undervalued or overvalued via P/E ratios, comparing them with fixed-income valuations through ratios like BEER can provide insights into relative attractiveness across asset classes. This multi-dimensional approach ensures that investors aren’t making decisions based on incomplete data or misleading signals.

In practice, this means investors should consider both absolute and relative valuation metrics, use multiple valuation methods, and adjust them to the current economic cycle. During boom periods, they may need to raise their valuation thresholds slightly to account for higher risk appetite and elevated earnings growth. During recessions or periods of high uncertainty, they may need to lower their benchmarks to reflect compressed valuations and higher risk premiums.

By doing so, investors can avoid two common pitfalls: remaining underinvested in a long bull run while waiting for ‘cheap’ valuations, or overpaying for assets during periods of uncertainty, when the risk-adjusted fair value is lower.

In the end investors who understand that the mean is a moving target are better positioned to navigate long bull markets without frustration and deep bear markets without misjudgment. Rather than clinging to rigid historical benchmarks, they adapt their valuation framework to the underlying economic cycle—the tide that ultimately lifts or lowers all boats. This, combined with a multi-metric, context-aware approach to valuation, offers a disciplined yet flexible framework for long-term investing success.

Manuj Jain is a chartered financial analyst (CFA) charterholder co-founder of ValueMetrics Technologies.