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Mean reversion: A theory suggesting that prices and returns eventually move back towards the mean or average.

Reversion to the mean ((NYSEARCA:RTM)) doesn't get much respect. For over four years, markets have made it appear to be a quaint anachronism that has done investors more harm than good. Since 2009, the S&P 500 has been above its 200-day exponential moving average over 80% of the time (fig. 1). It has also spent much of that period flirting with Bollinger bands that normally represent the top 5% of data points (fig. 2). Can RTM now be safely ignored? The answer is an emphatic "No!" Reversion to the mean is a relevant and powerful influence on stock prices that is ignored at one's peril.

Figure 1.

Figure 2.

Titans of Finance

In mathematics, basic reversion (or regression) to the mean is "if a variable is extreme on its first measurement, it will tend to be closer to the average on its second measurement." In investing, it has a broader meaning, and variations have been promoted by many of the best financial minds of our time:

  • Jeremy Siegel, in Stocks for the Long Run (2006), describes the mean reversion of equity returns, and refers to returns "clinging" to a statistical trend line.
  • John Bogle, in The Telltale Chart (2002), states "…reversion to the mean is the rule, not only for stock sectors, for individual equity funds, and for investment strategies that mix asset classes, it is also the rule for the returns provided by the stock market itself."
  • Robert Shiller, in his classic Rational Exuberance (2005), says "Thus there is a sort of regression to the mean (or to longer-run past values) for stock prices: what goes up a lot tends to come back down, and what goes down a lot tends to come back up."
  • Jonathan Lewellen, in Temporary Movements in Stock Prices (2001), states "Mean reversion in stock prices is stronger than commonly believed. ... The reversals are also economically significant."

Beyond the Basics

Daniel Kahneman, Fama and French are other highly respected RTM proponents. Most have proposed causes beyond the basic math. Researchers have referred to "forces of mean reversion" (Siegel), a "compensatory effect" (Siegel), a "stationary component to stock prices" (Ho and Sears), or more prosaically, investing strategies that seem to confer an advantage will probably cease to work as investors flock to exploit them (Shiller).

Where Has Mean Reversion Gone?

While stock indexes, PE ratios, individual stock prices and other metrics have spent most of the last four years above their means, the efficacy of mean reversion has been masked, not eliminated. Many factors affect prices. We will only know after the fact which factors are responsible for the lengthy time above averages, but several oft-discussed possibilities are:

  • Quantitative easing, which has added up to a trillion dollars of new money into the U.S. economy each year
  • Suppression of interest rates, which has made borrowing money cheaper than any time in history
  • Restructuring business operations to reduce costs and maximize profits

What these and other possible causes have in common is that they are temporary, and most are nearer to the end than the beginning. QE is winding down, the Federal Reserve has made it plain that interest rate suppression must and will come to an end, and after 4 years, the "lean and mean" corporate restructuring is past its peak. As the effects of these and other factors dissipate, mean reversion will follow. Further, one of the common extensions to RTM, best stated by Bronson (2010), is that investments

"…do not return to normal levels on a smooth glide path by what is called 'reversion to the mean.' Instead, like a pendulum, valuations swing through the long-term mean to a level as proportionally undervalued as they were previously overvalued."

Apple: Poster Child For Mean Reversion

There's no finer example of this phenomenon than Apple (NASDAQ:AAPL). Since the introduction of the iPad in 2001, Apple floated above all means with a string of groundbreaking products and the incomparable Steve Jobs. Over time, competitors such as Samsung and Android eroded Apple's advantages, Jobs died, and all it took was a new product (the iPhone 5s) slightly less dazzling than the others to make Apple stock drop below its mean and spend most of 2013 there. To the dismay of those who bought Apple at $700, no advantage is permanent. Apple moved back above its long-term moving average, but as of today, is back below (200-day EMA= $508; Jan. 30 close = $501).

Investment Implications

The table below shows what happens when two indexes and three widely-held companies move first to their mean and then as far below their 200-day EMA as they were above it at their 2014 market highs. Because RTM theory says individual data points have a large random component, the highs here are averages for January 2014.

S&P 500

DJIA

Amazon
(NASDAQ:AMZN)

ExxonMobil
(NYSE:XOM)

Google
(NASDAQ:GOOG)

2014 avg. high

1820

16192

395.87

99.12

1149.40

Mean (200-day EMA)

1696

15336

325.80

91.96

941.53

Distance to mean (%)

-124 (-6.8%)

-856 (-5.3%)

-70.07 (-17.7%)

7.16 (7.2%)

207.87 (18.0%)

Equal amount below mean

1572 (-13.6%)

14480 (-10.6%)

332.94 (-35.4%)

84.80 (14.4%)

733.66 (36.0%)

1/30/14 price

1794

15849

403.31

95.11

1106.92

Target below 1/30/14 price (%)

-222 (-12.4%)

-1369 (-8.6%)

-70.37 (-17.4%)

-10.31 (-10.8%)

-373.26 (-33.7%)

If prices go as much below their 200-day EMA as they have recently been above it, the averages will drop into correction territory, as will investments tied to them like the SPDR S&P 500 (NYSEARCA:SPY) and SPDR Dow Jones Industrial Average (NYSEARCA:DIA). The widely-held stocks here will suffer losses from 10.8 to 33.7 per cent. The point of this chart is not that stocks will go down, rather, it quantifies the potential effect of RTM at this time.

Summing up

Reversion to the mean is considered a potent force by many of the greatest minds in finance. Seemingly contrary to theory, four years of stock prices and indexes have stayed above their moving averages. This indicates the de facto presence of economic factors that have kept prices higher, although which factors are now determinative is a subject of continuing debate. With the inevitable demise or replacement of these factors by others which are not as positive on balance, RTM predicts a fall in prices below the mean proportional to the degree to which price has been skewed above it. The timing of this process is uncertain, of course. If imminent, major indexes will see drops of 8-12% from current levels and the companies profiled here could fall 10-33%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Mean Reversion: Ignore At Your Peril