Mean Reversion

It seems my last weekly mail „Double Standards“ hit the nail on the head. I received many very positive feedbacks and exciting comments. One of them I would like to share with you: „people’s outrage is definitely selective, and the selectivity conveniently coincides with people’s preexisting political objectives. Stories attributed to anonymous (and, one often suspects, nonexistent) sources are also commonly used to justify political positions. The pressure to join one of two extreme sides and abandon individual thought is also very real“. Very well formulated, I am happy to say!

Today I would like to concentrate on what is called the theory of „mean reversion“.

In capital market theory, the term mean reversion is an extension of regression to the mean by negative autocorrelation to market price and volatility changes. This may sound a bit complicated, but it is not. In other words, the theory suggests that asset prices and historical returns eventually will revert to the long-run mean or average level of the entire dataset of an explicit asset and is thus focused on the reversion of only relatively extreme changes, as average growth or other fluctuations are an expected part of the paradigm.

The mean reversion theory is used as part of a statistical analysis of market conditions and can be part of an overall investment strategy. It applies well to the ideas of buying low and selling high, by hoping to identify abnormal activity that will, theoretically, revert to a regular pattern. The theory implies that markets tend to exaggerate and that they correct themselves over time not only randomly, but have a „memory“ and reverse previous trends. (As some of you may notice, this theory is in contrast to the „market efficiency“ hypothesis, a theory I will cover in my next weekly mail).

Therefore, an excessive increase in the price of an asset means that it must come down to more „normal“ levels in the future and vice versa. The extreme case is speculative bubbles. The same applies to volatilities and sales volumes and mean reversion for series running into the future means that in the long run, yield rates and interest rates do not just fluctuate around a mean value, but virtually actively return to it.

Ladies and Gentlemen, to be frank, this is a theory and not a 100% bulletproof investment truth. However, I think it is always interesting to look at the long price-trend-lines of an asset and ask yourself why the current price is above or below such a long price-trend-line and if there may be in one way or another an exaggeration in the market, offering an investment opportunity for long-term investors. You know, this theory has led to many investment strategies that involve the purchase or sale of stocks or other securities whose recent performances have significantly differed from their historical averages. However, a change in such returns could also be a sign that a company no longer has the same prospects it once did, in which case it is less likely that mean reversion would occur, and therefore the theory could not be applied in every case. Percentage returns and prices are not the only measures considered in mean reverting; interest rates or even the price earnings ratio (P/E) of a company can be subject to this phenomenon.

Please feel free to share your ideas and thoughts with me, but please do not forget (instead of hitting the reply button) to send your messages to smk@incrementum.li
Many thanks, indeed!

And now, Ladies and Gentlemen I wish you a great day and weekend.

Yours truly,

Stefan M. Kremeth
Wealth Management
Incrementum AG

Tel.: +423 237 26 60
Cell: +41 79 303 48 39
Im alten Riet 102
9494 Schaan/Liechtenstein
Mail: smk@incrementum.li