The mystery of mean reversion

One of the things I find fascinating about markets and the economy is the tendency towards mean reversion. Rather than taking a random-walk, markets seem to shuffle back in forth, contained within a tight range of possibilities. One of the places you see this is with the stock market averages. In Jeremy Siegel's book, "Stocks for the Long Run", he shows a plot (need a link) of the stock market average from 1830 to the present. Amazingly, it is nearly a straight line (on a log-axis) when corrected for inflation which indicates a steady 6.9% return over long periods of 30 years or so. In the shorter term, there are "wiggles" like the great crash of 1929 and the great bull market of the 1990s but over long periods you see it return to the trend. Other investments like bonds or real estate or gold do not show any kind of regularity. Stocks do not behave as a random walk, where the next move is simply random. Even though the country has changed dramatically from a agricultural economy to an industrial economy and then finally a service economy, the stock market returns have not changed a bit. Over 30 year periods, you simply get a 6.9% real return just like you always have.

Well, this isn't a history class. What does this mean for investors? There are a number of useful things to take away from this. Lets stick with the stock market averages for now. For one, it means that the current prices of stocks are not really the best predictor of where they will likely be in the future. This contradicts the Efficient Market Hypothesis (EMH) which says that the current price of stocks is really the best predictor: the price tells you everything and the trend tells you nothing. Mean reversion says the best predictor is really the trend itself. If your below trend, then your most likely to move upward back to the trend. If your above the trend then the opposite is more likely to happen. The long term data clearly indicates that mean reversion and not random walks is a better description of the stock market averages. In other words, in times like 1980 when stocks were well below the trend, we should have known better and simply loaded up on stocks. It should have been a no brainer and of course it is in hindsight. We were way below trend and they were practically giving stocks away. Of course most people hated stocks then. Business Week had their famous "Death of Equities" cover. In the opposite extreme was 1929 and 1999 when we were way above trend but crazy about equities. Using the insight of mean reversion should have convinced people to pull out and ignore stocks for a while. Of course we know what happened. The bubble bursted and we heading back to the trend. Surprise, surprise.

Other places that you see mean reversion is with whole industries. Banking for example goes through periods of high profits and periods of low profits. Same with insurance companies. Real estate also has these cycles. By understanding that these cycles are temporary and actually acting on this insight, you can out-perform the indices. Of course, not everyone can do this anymore than everyone can be taller than average. There seems to be some principle that keeps the average person at a 6.9% return. The goal of the stock picker to be better than average. But clearly only a few of us can do this. Others need to underperform and most will simply cling to the average by buying index funds.

The value investor is someone who tries to appreciate this principle of mean reversion. They seek to buy things that are out of favor and probably performing below average. The hope is that, as usual, things will change and this company's fortunes will change for the better. If the company is selling for a cheap enough price, then it will appreciate quickly when things begin to change. In my opinion, the best places to do this are with older companies that have survived many such cycles. For example, buy high quality and conservative insurance companies when profits are lower than usual. This is usually when there is a soft market and many companies are jumping into insurance and fighting for market share and so lowering prices. This eventaully will change when there is a crisis and these new companies become unprofitable and start to pull their capital from the insurance business. This allows prices to rise and the old stalwart insurance company becomes more profitable again. Other examples. Buy home builders during a housing crash (like now). Buy industrials during a recession.

The key is that you may have to wait a a while to get good returns. It is very difficult to forcast accurately when things will change. In fact it is probably almost useless to try to guess since the Market is a great discounting machine that is trying to determine this before you do. Marty Whitman has said that you should try to buy at the point of maximum fear. Of course you never know that you have reached this point. Buffett has said to "be feraful when others are greedy and greedy when others are fearful". However getting the timing right is difficult at best. Buffett has made the point that what you really do is simply try to figure out how much the company is worth as the total discounted cash flow (DCF) over its lifetime. This is the long view and to do this you need to assume that things will revert to the mean. You should not simply extrapolate the present situation because that is what the Market does. To beat the market, you should use the principle of mean reversion.

Why do things revert to the mean? That is the great mystery and we will leave that one to the philosophers and the social scientists. What an investor needs to know is that for whatever reason it is simply a proprerty of the markets. To beat the market averages you should work it into your investment scheme. If everyone did this and we had a market of DCF robots then maybe this wouldn't work. But Markets are controlled by people and people are afraid to lose money and get more afraid as security prices drop. This makes them ignore mean reversion and miss opportunities that value investors take advantage of. This is unlikely to change anytime soon as it appears to be simply a part if human nature. If we can resist these human emotions and invest more objectively, we have a chance at above average returns.