Mean reversion is a financial concept that suggests that things tend to return to their average or usual levels over time. For example, if a stock price is unusually high or low, it is likely to eventually move back towards its average price. This is based on the idea that extreme or abnormal conditions are temporary and will correct themselves in the long run.
Full definition
Whereas the industry continues to debate the efficacy of Shiller P / E reversion, we at Research Affiliates firmly believe in
mean reversion in asset prices (Brightman, Masturzo, and Treussard, 2014), although we acknowledge it to be tricky to accurately forecast.
There may be, on average across sampled gurus, a net trend following aspect that does not adequately account
for mean reversion in stock market returns.
What we found was that the majority of ETF
mean reversion trading strategies continued to perform as well as they had over the previous 15 years.
This view is broadly supported by other research
on mean reversion in earnings that I have discussed in the past, which has suggested, somewhat counter-intuitively, that in aggregate the earnings of low price - to - book value stocks grow faster than the earnings of high price - to - book value stocks.
The level of success possible
with mean reversion strategies may be surprising to some traders.
Dividends and growth tell us what to expect companies to produce for their shareholders, and relative prices tell us what to expect
from mean reversion in the price of that production.
I've had great success using short -
term mean reversion trading strategies on the VXX for several years now using your «Before Trade Entry» method and found that it does indeed make these high risk / high reward volatility ETF strategies tradable by lowering the drawdowns that are experienced without sacrificing too much of the high returns.
Then the book gets gritty, and looks
at mean reversion of companies that have done poorly over the last four years.
The results below show how
mean reversion works on the worst performing country funds versus owning an international index fund.
Provided we're willing to tolerate some additional noise, due to points where
mean reversion did not occur during the projection horizon, we can even examine the relationship between valuations and likely 6 - year total returns.
Does the stop become beneficical (reduce max drawdown) for
mean reversion when the stop is placed k x MAE away from entry price?
At the simplest level, Hussman's arguments are
about mean reversion of earnings yields, something that even diehard bulls like Siegel admit to.
assume mean reversion at some point, and wait for a better pitch), and then asks, «What if my choice is wrong?»
First, some of the
strongest mean reversion in the capital markets occurs between past and future earnings growth rates.
That said, we would also point out the investment style has displayed a consistent pattern of
mean reversion over more than 100 years.
Perhaps fund -
return mean reversion comes primarily from fund factor exposures and factor valuation cycles.
Mauboussin's research supports Graham's view that, while some businesses do generate persistently high or low returns on invested capital beyond what chance dictates, there exists a strong tendency
toward mean reversion in most businesses.
When we explain the intuition behind half - life of
valuation mean reversion in this article, we assume the second effect is significantly stronger.
I should also note that
mean reversion tools, such as the 10 and 20 EMAs, work best in a trending market.
It is possible he based his guess on fundamentals that indicate rebalancing is often a source of return in commodity investing
where mean reversion works by capturing systematic opportunities.
«When I think of long / short business, to me there's 5 ways to make money: 2 of those are you either
play mean reversion, which is what a lot of long / short strategies do, or you can play momentum / trend, and that's typically what I do.
In pursuit of the idea that it is a failure to incorporate
mean reversion into growth forecasts, Lakonishok et al undertake a really interesting examination of the data.
The common factor of
most mean reversion strategies like the CAPE, the Magic Quadrant and the Acquirer's Multiple is avoiding the effort of valuation.
In other words, analysts are doing nothing more than projecting the relatively recent past into the future, but they're assuming trend continuation while using timeframes at
which mean reversion becomes applicable.
I remember seeing a study that
showed mean reversion in businesses; high margin businesses go back to low - to - average margin, high return on cap goes to normal, high earnings growth peters out to low growth... negative to low growth goes up to average or high growth etc..
MDD / MDU strategies take advantage of the tendency of ETFs to demonstrate
mean reversion behavior in the short - term.
As I ventured into different type of quantitative trading, I was fascinated
by mean reversion strategies.
From an international perspective, the United States enjoyed a particularly favorable climate for asset returns in the twentieth century, and to the extent that the US may
experience mean reversion in the current century, «safe» withdrawal rates may be overstated in many studies.
The current case for non-US versus US equities supposes an
eventual mean reversion in historically divergent performance and valuation trends.