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# Portfolio Analysis - What If Mean Reversion Works?

At times when the market is down, or plagued with uncertainty, it can be comforting to take a look at what would happen to the portfolio if stocks reverted to the mean, whether by one of the common metrics or by reaching their target or fair values.

I maintain a copy of my portfolio on Morningstar, because their system makes a great deal of information available to be downloaded to an Excel file, including some statistics I think are particularly useful - Morningstar's estimate of fair value, 5 year average P/B, and 5 year average P/S.

Downloading to a spreadsheet, and doing the computations, if the portfolio stocks were to revert to their 5 year average P/B, the portfolio would increase by 66%. For P/S it would be 63%, and for fair value, 39%. Not too shabby. That would resolve a lot of problems.

My portfolio consists primarily of LEAPS, long term in the money calls, used as a substitute for share ownership, with shorter dated covered calls sold against them. This arrangement affords substantial leverage, which cuts both ways.

To figure out the amount of leverage, it's possible to use delta. However, today I'm simply treating each long call as the equivalent of 100 shares, on the ground that if the option is still in the money at expiration, delta will go to 1. As for the covered calls that have been sold, they are out of the money and the plan is to roll them up and out if the underlying increases enough that they are at the money. If they are out of the money at expiration, delta will go to zero.

Applying that line of reasoning to the mean reversion scenario, fair value would be an increase of 178%; P/B would be 299%; P/S, 283%. That would average out to 253%. Even if I only get half, it would still be 127%. I did a similar computation around the bottom in March 2009 and wound up getting about half, so that is probably realistic.

How long does it take for mean reversion to work? About two years is long enough, by then there will be clarity about a lot of the issues that are keeping share prices under compression. The S&P 500 would have to hit 1,450, pretty much in line with what analysts were looking for by the end of this year.

There is a lot of risk out there, but with the rewards if I'm right being what they are, I plan to hold my current positions and monitor developments.