Short-Term Mean-Reversion Becoming Stronger: So What?

This is the final post about the short-term (daily) stock market mean-reversion becoming stronger (read part 1, part 2, and part 3), and will wrap up the discussion on the subject. So far, this has been a pretty geeky conversation and I’m afraid that I still haven’t answered the most important question - so what?

Well, if you’re a trend-follower or buy and pray type, none of it matters. More importantly, if you’re unable to minimize your transaction costs, then none of it matters.

However, if your trading resembles anything like ours (swing trading near-daily with low transaction cost vehicles**), then all of this definitely matters.

Below are two examples of short-term strategies that have been positively impacted by the acceleration in short-term mean reversion.

Adaptive Daily Follow-Through

This is the same short-term strategy I talked about in The Simple Made Powerful with Adaptation and that I track daily on the free State of the Market report.

Strategy performance frictionless (red) versus S&P 500 (blue) from 1955:

click to enlarge

[logarithmically-scaled]

Note the strength of the strategy’s performance today (right end of graph), not seen since the 60s and 70s. Enough said.

For all intents and purposes, these results could be duplicated in today’s market (net an annual fund expense ratio) using leveraged mutual funds. (Please see my note at end of post.)

Scotty Strategy

Long-time readers know that I never release backtested performance for my proprietary programs because it fundamentally goes against my belief that investors should base their investment decisions on actual results (read why), but I’m bending my rule a bit to prove a point.

This is a backtest of my newest strategy, Scotty, from 2000 including all transaction costs (but excluding our 2.5% annual account management fee):

click to enlarge

[logarithmically-scaled]

Note the uptick in performance in the last year. Scotty isn’t purely a short-term strategy, but the short-term component of the strategy is really taking off, directly as a result of the increase in daily mean-reversion. Enough said.

The point of these two examples is to say that, at this moment in time (subject to change with a portfolio-crushing lack of notice) short-term mean-reversion is the stock market play du jour. Not respecting this shift in the markets and following the CNBC’esque view of the world (the market rallied today, the bottom is here!) is quite possibly the easiest way to underperform even the sad saps on Wall Street.

** Side note: Because I’m asked after every post where I talk about low/no transaction costs vehicles, I’ll answer in advance : I only trade leveraged mutual funds from Rydex, ProFunds, and Direxion (not to be confused with leveraged ETFs), that are designed to be actively-traded. These do not carry per-transaction costs and exhibit high r-square to their underlying indices (meaning, unlike ETFs, they track their indices very tightly). The downside of these of course is that they do not allow for intraday orders (stop, limits, etc.)