Respect the Power of Mean Reversion

“From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.” – Jason Zwieg

Investors love to tell themselves stories to explain why things happen the way they do with their investments. It makes us feel better when we buy a stock if there is a nice narrative for that particular company. That’s why technology stocks have always been so appealing to investors.

Buying companies that promise innovation and exponential growth is exciting while also giving you the ability to sound smart about your investments around your friends.

The same holds true for all investments. We love to explain why country A’s stock market is up this year but country B’s market is down.  The financial media loves these narratives as well.

It’s the Fed or inflation or interest rates or currency fluctuations or the price of oil or dividend rates or blah, blah, blah

While these factors do all play a role shaping the markets over time, most of us miss out on the simple explanation for why certain investments outperform others. The common sense answer is actually mean reversion.

Mean reversion is simply the fact that investments can trade far above or far below their long-term average returns for periods of time, but in the end they eventually tend to move back towards their average.  Outperformance is followed by underperformance and vice vera.

Let’s take a look at a few recent examples to see mean reversion in action. For each of these I will give you the market or asset, the story that the media wants you to believe and then the actual reason for the changes in the investment.

EMERGING MARKET STOCKS
The Story: As the Fed has continued to “print money,” emerging market economies are being hurt by rising levels of inflation. Economic growth in places like China and Brazil is coming down from lofty levels in the past so capital is exiting these countries.

US stocks are widely considered the best house in a bad neighborhood with companies having the ability to take on debt at extraordinarily low levels of interest rates to issue dividends and buy back shares.

Many emerging market economies have their economic fate tied to the prices of raw materials and commodities, which have seen prices drop substantially in the past year.

Because of the slowing growth and rising inflation, emerging market stocks were down over 12% year to date through the end of June while US large, mid and small-cap markets were all up by well over double digits.

The Real Reason: From the year 2000 until 2009, emerging market stocks were up by over 160% or more than 10% per year. During that same time frame, the S&P 500 was actually down by a total of almost -10% or nearly -1% per year.

Emerging markets have been one of the few bright spots for economic and stock market growth in the past decade.

Isn’t it possible that the economic growth was baked into those strong returns in the first part of the decade and now the stock performance of these developing nations is now coming back towards their long-term average?

And isn’t it also reasonable to assume that coming off one of the worst decades of returns on the S&P 500 that the performance would be better coming out of that horrendous decade?

That is exactly what has been happening. The Fed, the value of the dollar and the level of commodities sounds like an interesting theory. And those factors are probably playing a part in this story.

But what’s really driving these returns is the fact that investors made some good money in emerging markets and decided to look elsewhere for markets that offered more value. That place just happened to be in the US.

I can’t predict the future, but after the nice run up we’ve had for the past five years or so, it will probably make sense to look for markets that offer better value than the US markets do currently.

I don’t recommend wholesale changes to your asset allocation, but if you don’t have any international or emerging market stock exposure, these are two markets that are widely hated by investors at the moment.

If you are in it for the long haul, looking to rebalance into undervalued markets is one way to increase your long-term results. These things don’t always reverse right away, but buying undervalued assets and selling overvalued assets is the goal of buy low, sell high.

GOLD*
The Story: Gold just had its worst quarterly performance in decades, falling by well over 20% in the second quarter. Inflation is at 50 year lows, so real interest rates remain low. Plus, the Fed briefly began to talk about tapering their bond purchases which was a large reason many investors wanted to own the metal in the first place.

So, as the story goes, gold sold off.

The Real Reason: Gold actually rose for twelve straight years from 2001 to 2012, going from a price in the $200s all the way up to just shy of $2,000. That’s a pretty good upswing.

Isn’t it possible that after 12 straight years of gains that gold was due for a pullback? Isn’t it also possible that the investors buying in at the high prices in 2011 and 2012 were doing so because they witnessed the great returns in the past 10+ years in gold as the real reason for their investment?

Guess who got caught holding the bag when investors rushed for the exits? The last investors to buy in, of course.

There are many reasons that caused investors to sell gold, but the easiest explanation remains that after 12 years of gains, it was probably due for a pullback. That’s how mean reversion works. Investments can’t grow to the sky forever or else everyone would invest in them and never sell.

HOW TO TAKE ADVANTAGE OF MEAN REVERSION
Asset allocation doesn’t work without diversification which doesn’t work without rebalancing which doesn’t work without mean reversion. Make sense?

The point of choosing an asset allocation is to diversify your investments in a number of different geographies, markets and companies. And rebalancing allows you to sell some of what has worked and buy some of what hasn’t worked.

The only reason to do this exercise is if we believe that markets will tend to mean revert over time. The timing is always different, but this will work out for you if you are patient and think long-term. Michael Mauboussin, one of the best investment minds around today, had this to say on the subject recently:

“Importantly, reversion to the mean in the investment business extends well beyond the results for mutual funds. It applies to classifications within the market (small capitalization versus large capitalization, or value versus growth), across asset classes (bonds versus stocks) and spans geographic boundaries (U.S. versus non-U.S.). There are few corners of the investment business where reversion to the mean does not hold sway.”

Now, when I talk about mean reversion, I am referring mostly to broad markets, not esoteric individual small-cap stocks or whatever else people trade in these days. Individual securities don’t have to mean revert. But most of the time, value vs. growth or small-cap vs. large-cap or country vs. country do tend to revert to the mean.

It makes sense to diversify while systematically rebalancing to sell some of our winning investments and buy some of our losing investments. This forces you to take profits and reinvest them at lower prices. Another example of buy low, sell high.

Excessive optimism or pessimism tends to make us think it’s different this time when something goes up or down by a large amount. Past history shows us that reversion to the mean usually happens when something goes in one direction, both up and down, for too long.

I see no reason why this will change going forward as long as investors are always in need of undervalued investments.

Sources:
Morningstar

*Unfortunately, even though gold was overdue due for a short-term bounce, I can’t recommend that investors allocate part of their portfolio to the yellow metal. It’s too volatile, doesn’t produce earnings or pay interest, and is simple impossible to value. It doesn’t fit my common sense investment guidelines. I can see why some investors have a small allocation (say 5%) for diversification purposes, but gold is not for me. Here’s Mr. Buffett’s take if you are interested:

“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion – that’s probably about a third of the value of all the stocks in the United States…For $7 trillion…you could have all the farmland in the United States, you could have about seven Exxon Mobils and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”

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    […] Mean reversion teaches us that periods of higher than average performance tend to lead to periods of lower than average performance since the good times can’t last forever. That’s exactly what we may witness with future bond returns. […]