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posted on 17 October 2017

Reversion To The Mean: Is That Really A Thing?

Written by , Clarity Financial

The reality is that all markets eventually “revert to the mean" which is described as:

“Mean reversion is the theory suggesting that prices and returns eventually move back toward the mean or average. This mean or average can be the historical average of the price or return, or another relevant average such as the growth in the economy or the average return of an industry."

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Mean reversions occur both from levels above the long-term moving average (bear markets begin) and below (bull markets begin.)

The deviation from long-term moving averages from the S&P 500, on various time scales, is at levels that have historically always preceded a mean-reverting event. The charts below look at the deviation above moving averages on a daily, weekly, monthly, quarterly and annual basis.

The first chart is the percentage distance between the price of the market and the 200-day average price. Historically, when the deviation approaches 10% or greater, the risk of a reversion increases.

Does it happen immediately? No.

Does it happen? Yes, every time.

Stepping back to a weekly basis, the same can be seen that deviations above the 1-year moving average of 10% or greater have also been predictive of reversions.

NOTE: To go back further in history, the next 3-charts use the Shiller Data, versus the S&P data above. I have also used the inflation adjusted price of the S&P 500 for the next three charts.

Looking back even further into history, deviations of 10% or greater from the 3-year moving average have denoted markets closer to a peak, than the beginning of a bull market cycle.

The same is true for quarterly data and a 4-year moving average.

As well as annual data and a 6-year moving average.

Here is all you need to take away from the charts above:

“All bull markets end. Period."

More importantly, note that during ANY time period you observe, a mean-reverting event NEVER occurred by prices going sideways. There was always a decline, a correction, a bear market or a full-blown crash.

Regardless of what current reasoning that we wish to apply that somehow “this time is different," it simply isn’t, and the ultimate outcome will be the same that it always has been.

As Vitaliy Katsenelson penned last week:

Starved for yield, investors are forced to pick investments by matching current yields with income needs, while ignoring riskiness and overvaluation. Why wouldn’t they? After all, over the past eight years we have observed only steady if unimpressive returns and very little realized risk. However, just as in dating, decisions that are made due to a “lack of alternatives" are rarely good decisions, as new alternatives will eventually emerge - it’s just a matter of time.

The average stock out there (that is, the market) is very, very expensive. At this point it almost doesn’t matter which valuation metric you use: price to ten-year trailing earnings; stock market capitalization (market value of all stocks) as a percentage of GDP (sales of the whole economy); enterprise value (market value of stocks less cash plus debt) to EBITDA (earnings before interest, taxes, depreciation, and amortization) - they all point to this: Stocks were more expensive than they are today only once in the past century, that is, during the dot-com bubble."

Ironically, or not, Jason Zweig from the Wall Street Journal just wrote much the same thing:

“Old bull markets don’t produce new ideas. They just produce new ways for investors to hurt themselves with old ideas.

With stocks at record highs and the income on bonds not far from record lows, circumstantial evidence suggests investors are getting restless - if not desperate.

Chasing ‘yield,’ or trying to get higher investment income, is one form of desperation. Last month, $1.6 billion in new money poured into exchange-traded funds holding high-yield corporate bonds, according to FactSet.

Another aspect of the problem: The longer markets go on producing decent performance at little apparent risk, the more investors come to believe that high returns must be a kind of entitlement."

The reality is that investors who are stampeding into expensive stocks through passive index funds are buying what has worked. Chasing performance has always been the hallmark of overly bullish, overly extended and exuberant markets. It will, as always, eventually stop working.

As Vitaliy concluded:

“In 2016, less than 10 percent of actively managed funds outperformed their benchmarks (their respective index funds) on a five-year trailing basis. Unfortunately, the last time this happened was 1999, during the dot-com bubble, and we know how that story ended."

To summarize the requirements for investing in an environment where decisions are made not based on fundamentals but due to a lack of alternatives, we are going to paraphrase Mark Twain:

‘All you need in this life [read: lack-of-alternatives stock market] is ignorance and confidence, and then success is sure.’"

What We’re Doing Now

It is that large deviation from the moving average that has us currently taking the following actions within our portfolio management process.

  1. Added bonds to portfolios across the board with the recent spike in interest rates which suppressed bond prices.
  2. Trimmed exposure in positions that were extremely overweight.
  3. Moved stop levels on all positions to recent support levels.
  4. New accounts - we swept excess cash into our cash management model to improve yield.
  5. New accounts - holding cash slotted for equity allocation until a better risk/reward opportunity is presented.

As I have repeatedly stated over the last several months, while I may consistently point out the “risks" that currently prevail in the markets, our portfolios remain long-biased. But positioning will change when the current “bullish" trends become decidedly bearish.

When that occurs, or what the catalyst is that causes it, is currently unknown…to everyone. Ignoring the risks with the idea this time is somehow different, is not an investment strategy - it is “hope."

As Adam summed up last week (my edits in red):

“The stock market is now 70% 75% higher than it was at the previous bubble peak immediately preceding the 2008 Great Financial Crisis (and the crash)

Reflect for a moment how painful the crash from Oct 2008-March 2009 was. How much more painful will a crash from today’s much dizzier heights be?"

The chart below illustrates Adam’s point. There have only been two periods since the turn of the century where RSI on a 10-YEAR basis was above 70, as it is today, and both times ended poorly.

The market currently remains in an extremely bullish trend, but the opportunity to add “new money" to the markets will have to be waited out at this juncture.

We remain bullishly biased for now.

Importantly, we continue to remain invested.

However, we do so with a realization that every good party comes to an end.

We just plan to be gone before the police arrive.

If you’re the last one out…be polite and get the lights.

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