A Better Frame Of Reference, Mean Reversion And The S&P 500

by: Ironman at Political Calculations

Whatever happened to the echo effect? After all, it's been a couple of weeks since we last mentioned in any meaningful way - you would have to look pretty closely at the margin of our favorite chart in our post yesterday to even see it referenced.

Even though we're still rooting against it, given that it makes the math we do more complicated, filtering for the echo effect would still seem to be providing a better frame of reference for describing why the stock prices are behaving as they are. Here's the echo-filtered version of the alternative futures chart we presented yesterday:

Click to enlarge

For an example of why filtering for the echo effect would appear to provide a better frame of reference than the unfiltered version, let's look at the change in the value of the S&P 500 from Friday, 14 March 2014 to Monday, 17 March 2014. Here, after investors had fully shifted their forward-looking focus to the expectations associated with 2014-Q3 on Thursday, 13 March 2014, stock prices drifted lower on Friday so that they fell below the level where they would be if they were centered on that target.

Our hypothesis for how stock prices really work says that whenever they deviate from the level associated with the forward-looking expectations of investors, which we measure as the change in the year-over-year growth rates of trailing year dividends per share expected from one future quarter to the next, they will tend to move to the level that is consistent with the future quarter to which investors have focused their attention. And sure enough, that's exactly what happened on Monday, 17 March 2014, as investors maintained their forward-looking focus on the expectations associated with 2014-Q3, for the reasons we discussed yesterday.

Now consider this question - if stock prices truly do have the property of being mean-reverting, what defines where the mean is?

We like the alternative futures chart because, for us, it emphasizes the quantum nature of stock prices - that they chaotically move from one level to another like an electron orbiting a hydrogen atom as they either gain or lose energy. Only here, that happens as investors shift their attention from one alternative future to another and adjust their investment strategies accordingly to the expectations associated with the future upon which they focus.

So we find ourselves in the odd position of knowing what the future for stock prices is (or more accurately, what the alternative futures for stock prices are), or would be, provided that we can identify or accurately predict which future's expectations will signal and hold the attention of investors.

And yet, it's unpredictable because there are random and chaotic elements behind when those shifts might occur. We call that noise, which while causing stock prices to deviate from the targets investors would set, is necessary for the market to behave efficiently.

But that's a whole different topic for a different day.