Commentary ~ Mean Reversion Analysis in Everday Life ~ January 1st, 2015
Suppose you flipped a quarter 10times and each time it landed heads. You instinctively know that tails is likely to come up soon. Imagineyou have a golfing buddy who routinely shoots in the mid-90’s. One day he amazes you (and himself) by shooting an 8o for no explicable reason. Having observed many of your mate’s less-than-stellar rounds, you surmise that his next round will be less Tiger Woods-like and more like the golfer you know.
Experience tells us that unexpected outcomes are likely to revert back to the expected sooner or later. Whether it be coin-flipping, golf or any another activity that produces an observable outcome, we intuitively know that our cumulative observations matter more than the most recent. This behavior can be described as a form of mean- reversion analysis and it is an important element of our every day lives.
Mean-reversion is natural. Over time, nearly everything reverts to its mean, or average. For those that have taken a college statistics course, perhaps the simplistic beauty of mean-reversion analysis has been tainted by its close association with math. Nevertheless, we perform the basic calculations in our minds all the time and understand the
importance of such analysis.
Why do shoppers get excited about a sale? Because prices are lower than normal! And they know that when the sale is over prices revert back to normal. This is mean-reversion analysis. Mean-reversion analysis also works well when performing investment analysis. In fact, it is the cornerstone of Tandem’s proprietary investment process. When followed, this analysis can tell investors when stock prices are on sale and when they are too high.
So why is mean-reversion analysis so rarely used by investors, even professional ones? Too often investors get caught up in the hype of the now, or allow some past outlier experience to cloud the ability to properly analyze the situation at hand.
Presently, we see many investors split between two camps: those that believe everything looks grand and the market will continue higher and those that believe nothing is grand and the market is bound to fall precipitously once again. But a little bit of mean-reversion might suggest that neither outcome is the likely one. Not every reversion to the mean has to be calamitous or glorious. Most aren’t. But reversion always happens, and will happen again sometime.
The chart below illustrates the S&P 500 and it’s approximate mean over the past 55 years. The price of the S&P routinely travels along its mean, sometimes above it and sometimes below it. Yet each deviation inevitably results in a reversion. Therefore, it is reasonable to conclude that the best times to buy are when the price is below its mean and the best times to sell are when the price is above its mean.
Some may infer that this analysis leads to the conclusion that there are times to get into the market and times to get out of the market. We could not disagree more strongly! We believe that one should never time the market. Getting out and back in and out again and back in again is folly.
Rather, we believe that mean-reversion analysis is more useful when performed on a stock-by-stock basis with little attention paid to the overall market. Tandem has built an entire investment process around mean-reversion analysis. We apply it regularly to our universe of 1,600+ stocks, but never to “the market”. It is a lot of math and proprietary formulas, but it is straight-forward concept. We calculate our proprietary ratio for each stock and observe the ratio relative to its mean. When a ratio travels too far above its mean, we buy the stock. When it travels too far below, we sell a portion of the stock. Hopefully the chart below illustrates this. We can buy and sell with confidence because we know the ratio will ultimately revert to its mean.
By observing and evaluating individual stocks relative to their mean, we are able to buy and sell accordingly. If we were to follow “the market” we might infer that all stocks are behaving similarly. Sometimes they do, particularly when “the market” is at an extreme. But mostly they behave individually.
For the past year or so, we have found more stocks overvalued than fairly valued or undervalued. As a result, we have taken profits and not reinvested all of the cash we raised. This in no way reflects our opinion of stocks generally. Only that we have found more stocks to sell than buy – which means cash levels in our portfolios have been increasing. This makes our portfolios more defensive in nature right now because we are less fully invested then “the market” But selling does not take us out of “the market”. It simply reduces our exposure to overpriced stocks. Most stocks in our portfolios are still fairly valued, and some are even undervalued. By following our mean-reversion analysis, we naturally take profit in expensive stocks and wait for other stocks we like to go on sale.
As Benjamin Graham asserts in The Intelligent Investor, “price determines return”. In other words, paying a reasonable price is key to investment success. Fortunately for us, most investors would appear to ignore mean-reversion analysis. Or at least they seem to based upon observed behavior. If everyone practiced mean-reversion analysis, the market would be more efficient. We prefer to do the work required to discover its inefficiencies..
Mean-reversion analysis is by no means perfect. It is conceivable, albeit rare, that a stock may permanently break away from its mean and establish new territory, good or bad. We can live with missing out on the rare good exception. We simply want to avoid the bad exceptions. By doing so, we miss far more false opportunities than real ones.
We mentioned in our Market Commentary that the S&P has gone nearly 3 years without a real correction. Therefore, the S&P has traveled a bit north of its mean. It will revert. We don’t know when, But that doesn’t mean investors should get out of the market. The mean increases as prices rise. By the time the market reverts, the mean could conceivably be higher than current prices.
Instead of getting out of the market, we simply take some profit in individual stocks that have traveled too far from their mean. We are content to patiently hold cash as we wait buy stocks that are attractively priced. Mean-reversion analysis sounds terribly complicated. Perhaps even boring. But it works for us.