Reversion To The Mean

 A powerful phenomenon exists that is often ignored or overlooked during both bull and bear markets. This is possibly the case because many investors prefer a sappy narrative to an analysis based on mathematics and historical data points. In a financial context, "Reversion to the Mean" describes the tendency of a stock or stock index price to return to its average or "mean" value after deviating from it. This behavior is based on the premise that extreme price movements are often temporary and unsustainable in the long run. The basic principle is that what goes up must come down, and what goes down must go up. While the daily movements of the stock market may be chaotic and unpredictable, long-term stock market returns tend to follow a somewhat predictable upward trend. Deviations from this trend can last for extended periods, even decades. Mean reversion is not a consistently viable strategy for short-term trading. On the other hand, it is useful in identifying individual security valuation and overall market valuation relative to historical trends. 

The concept of mean reversion was first observed in the field of biology by Sir Francis Galton, a cousin of Charles Darwin. In his book, "Hereditary Genius" (1869), Galton set out to prove that human ability passes through the generations. He found some confirmation that the descendants and relatives of distinguished people were likely to contain great achievers among them. The effect, however, diminished over time. Only 36% of the sons of eminent men and only 9% of their grandsons were eminent. Galton also discovered that the same principle holds true for height. The children of abnormally tall people tend to be smaller than their parents, and vice versa. Without regression to the mean, the world would comprise of geniuses and dimwits, and giants and midgets, with nothing in between.

Examples of reversion to the mean abound. Major League baseball players who hit well in their rookie season are likely to do worse in their second season. The acclaimed "sophomore slump" is more than a myth. Likewise, regression to the mean is an explanation for the Sports Illustrated cover jinx - periods of exceptional performance resulting in a cover feature are likely to be followed by periods of more mediocre performance, giving the impression that appearing on the cover causes an athlete's decline. The hottest place in the country today is more likely to be cooler tomorrow than hotter. Another example, returning to the financial realm, would be the best performing mutual fund over the last three years is more likely to see relative performance decline than improvement over the next three years. The "Dogs of the Dow" investment strategy incorporates reversion to the mean to a certain extent. This strategy selects the 10 stocks in the DJIA at the beginning of the calendar year with the highest dividend yield. The theory holds that those companies are near the bottom of their respective business cycles and would thus exhibit a lower share price than if they were near the peak of their business cycles. The 10 companies near the bottom of the business cycle should have their share price appreciate more quickly compared to the other 20 companies in the Dow Jones Industrial Average.

Mean reversion investment strategies often incorporate specific technical indicators in the process of trading equities. These indicators help identify overbought or oversold conditions. The most prominent tool in this area would be the Relative Strength Index (RSI). The RSI is an oscillator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock. It fluctuates between 0 and 100. A high RSI (typically above 70) suggests the asset is overbought, while a low RSI (typically below 30) indicates oversold conditions. Traders adopting a mean reversion approach might buy when the RSI is low, anticipating a price rebound, or sell when the RSI is high, expecting a price correction. Another technical indicator used on a frequent basis would be Bollinger Bands. Bollinger Bands consist of a moving average and two standard deviations plotted above and below the moving average. These bands widen during periods of high volatility and contract during periods of low volatility. A stock price moving outside of the Bollinger Bands can signal an overextended move, suggesting a potential mean reversion opportunity.

In discussing Bollinger Bands in the previous paragraph, the term "standard deviation" was mentioned. In the world of statistics, standard deviations measure how far from the normal trend line data points have strayed. Two standard deviations cover 95% of all events and three standard deviations cover 99.7% of all events. The S&P 500 Index is currently 2.3 standard deviations above its historical trend line. The last time it pushed above two standard deviations was when it hit 2.2 standard deviations just prior to the Internet Bubble bursting in 2000. As a reminder, the NASDAQ lost 80% of its value during that particular drawdown. So, be careful, market participants.

For a long time, a popular strategy in the investment world was to simply buy solid companies and tuck them away forever. That's what was considered prudent investing. Investors didn't understand that bad companies are often too cheap and good companies often too expensive. The assumption was that companies would maintain a constant return on their retained earnings. The ROE is never constant, however. It's always changing. There is a systemic tendency for high returns to fall and low returns to rise, in both cases regressing toward the typical corporate return. Capital moves towards profits, whether it be in certain sectors or specific corporations within the sector. This leads to complacency among the "winners" and attracts new competition. It becomes more difficult for the wildly profitable entities to maintain their margins. Lower margins lead to lower stock prices.

Multiple studies confirm that the rate of mean reversion was not identical for every company. There are  two primary factors that can either accelerate or decelerate the pace of regression. Debt, especially a high level of leverage, speeds up the regression rate. The profits of a highly leveraged company are going to drop much faster when things turn bad compared to a company with little or no debt. The firms that display the qualities of a monopoly can slow mean reversion to a glacial pace. These companies are the price-setters in their industry with a dominant market position. Refer to multiple members of the Magnificent Seven (Meta, Google, Nvidia) for prime examples. So far, they appear immune to mean reversion. Their day will come. It's hard to defy the Laws of Physics. It's also hard to defy the Laws of Math and Statistics.

K-Shaped Economy

 One of the biggest economic buzzwords the past few years has been "K-Shaped Economy." Take a second to picture a K. The one line shooting up and to the right represents Americans who are financially doing great. They're mostly people who are heavily invested in the stock market, and that market continues to break records. And the line shooting down? That's pretty much everyone else. Essentially, the rich are getting richer, the poor are getting poorer, and the middle class is shrinking. The number of Americans considered to be middle class shrank from 61% in 1971 to 51% in 2023 according to a 2024 Pew Research report. While United States income inequality has trended higher for the better part of a half-century, the split between the haves and have-nots has become even more pronounced since the Covid-19 pandemic. Of even greater concern is the widespread prediction that the divide will continue to widen in the ensuing years. Following, I will look at the primary factors contributing to the growth in income inequality. After writing about the causes, I will go over some of the possible ramifications to the economy and society in general if the income/wealth chasm is not successfully addressed. Lastly, I will list a handful of possible solutions to close the gap.

The main culprit for the expansion and acceleration of income/wealth inequality is, of course, our federal government. The central planners in Washington D.C. have flooded the economy with government spending of all sorts and inflated the money supply via artificially low interest rates and QE for the last quarter of a century. These abhorrent fiscal and monetary policies have been especially egregious since the Covid-19 pandemic. The majority of Americans, especially working class Americans, have not recovered from the inflation surge precipitated by the government response to covid. While inflation has since moderated from its highs in 2022, the 25%-30% cumulative price increases since 2020 have been devastating to most household budgets. One-hundred dollars in 2019 has the same buying power as $127 today. Rising prices have largely eaten up wage gains, leaving low and middle income Americans struggling to make ends meet. A softening labor market along with fears that Artificial Intelligence adoption will displace large swaths of workers further sours many Americans outlook on their future financial prospects.

The "haves", on the other hand, are prospering and optimistic about the future. While lower-income households are increasingly relying on debt to make purchases, higher-income households are maintaining or increasing their spending levels. The top 10% of income generators are responsible for 50% of consumption on a national basis. This group is essentially "carrying" the economy and keeping it out of recession. Cumulatively, this richest 10% of American households also owns 70% of the nation's wealth. Over the past five years or so, a soaring stock market along with rising real estate values have generated more than $50 trillion in new wealth. Nearly three-quarters of the growth in consumer spending this past year can be attributed to what economists call the wealth effect: as people's net worth rises, they spend a fraction of their increased wealth. Asset owners, holders of stocks, bonds, and real estate, have made out like bandits the past few years. The same can't be said for Americans who own little or not assets.

The artificially low interest rates perpetuated by The Fed have directly fueled the staggering increase in asset values. Rates were depressed for over a decade (2008-2022). Multiple rounds of Quantitative Easing (QE) have also contributed to asset inflation. More and more monies chasing a finite number of assets has pushed stock markets and real estate prices into the stratosphere. That's great for homeowners, people with stock portfolios, and the wealthiest 10% who hold most of the country's wealth. The same can't be said for the seniors with modest savings accounts who rely on social security benefits and the young adults looking to form a family and to have children. There is a reason why about one in three U.S. young adults (ages 18-34) live with their parents. I can fully understand why members of the Millennium generation and Generation Z are miffed with the Baby Boomers.

History shows that excessive income concentration can weaken economic growth by lowering overall demand. Those with fewer resources depend on borrowing and accumulate debt until it's no longer possible. When these imbalances become unsustainable, the economy typically shifts from boom to bust. There is also no question that grossly unequal distribution of income and wealth can facilitate political polarization and tear at the social fabric of a nation. I don't see a second American Civil War or something like what happened in Russia in 1917, but capitalism will continue to be under threat as old coots head to either the nursing home or the cemetery and younger voters cast their preferences at the ballot box. A case in point would be the recent election of Zohran Mamdani in New York City. It would not surprise me to see additional politicians getting elected across the country who share Mamdani's socialist views.

Flattening the K-Shaped economy may be crucial for the nation's long-term economic and political health. A key question is whether technology (Artificial Intelligence) will help flatten the K-Shaped trend or do just the opposite. The cynic in me believes AI will exacerbate the problem. Although the government tends to make problems worse when it attempts to solve them, look for the government to introduce measures in an attempt to flatten the "K." This will primarily be done by revising the tax code with the goal of reducing wealth and income disparities. Fixing our antiquated, wasteful, and corrupt education system at all levels would hopefully facilitate a narrowing of the divide and offer disadvantaged students the possibility of dramatically improving their financial situation. In reality, the only surefire way to fix the problem is for deficits to be reduced, end The Fed's interventions, return to sound money, and let interest rates be determined in the markets. Don't hold your breath.

I offer the ultimate solution to the problem. However, most of my peers, if not all of my peers, are not going to like this quick and brutal solution. We could use a good, old-fashioned recession. One where overvalued real estate loses 30% of its value and the supremely overvalued stock market loses 50% of its value. I don't anticipate this happening. At the first signs of trouble, Congress will recklessly expand the annual deficit from 6% of GDP to 12% of GDP, while The Federal Reserve Bank cranks up the printing presses and floods the financial system with even more excessive liquidity. In other words, the proverbial can will get kicked down the road. Again.