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.