How I Use Mean Reversion

• Posted by Derek
• on November 5th, 2010

“People are inefficient(and slow) information processors and disinclined to let go of strongly held beliefs.” Dr. Phil Pearlman

I loved Phil’s discussion on the Mean Reversion Heuristic because I carry that bias, and took years of daily grinding to finally make it work for me instead of against me.  It’s incredibly helpful to hear a trained clinical psychologist discuss the biological reasons behind behavior we have noted in ourselves.  With the right attitude, we as market speculators can take a disadvantage and turn it into an advantage by recognizing our flaws and channeling them into productive use.

Leaving the reasons for our behavior to the professionals, I’d like to share how I embrace trends but incorporate natural mean reversion wiring into my strategies.  Let’s start with my philosophy…I think markets have some factors that trend and some that mean revert.  The key is to use the right tool for the right job.  Among market characteristics I believe the following can be categorized:

Mean Reverting Characteristics:    Sentiment, Valuation, Profit Margins, Asset Class Popularity

Trending Characteristics:   Sales, Earnings, Government Spending, Stock Prices

The themes are very powerful…there is a general tendency for news flow to continue in one direction, but an oscillating pattern in how market participants respond to that news flow.  In a perverse fashion George Soros described as reflexivity, it’s often the disbelief by mean reverters that provides fuel for emerging trends to expand…their decision to ignore the new trend, or worse fight it, creates a pool of future converts forced at a later date to reconcile the growing battle between their opinions and reality.  Sometimes the passage of time is enough to present the “A-ha” moment that things have changed, but sometimes their hand is forced by clients, employers, or our friend the margin clerk.

To what do I attribute the ability of price to trend while measures like sentiment and valuation mean revert?  Besides the obvious psychological defects we carry, I believe there is a fundamental reason…underestimation of leverage.  Not leverage as in a margin account, though this serves its own role in amplifying our emotions.  I’m talking about corporate leverage. If we weren’t aware of the effects of financial leverage on financial companies, we certainly learned it in the 2008 meltdown.  Since that lesson has been learned, I’ll touch briefly on my thoughts on operating leverage, which serves up a slower form of profit creation and destruction but I believe gets underestimated by trend fighters.

A company with a rapidly growing(or declining) sales base rarely hires(or fires) at the pace its business is trending.  So on the right or wrong side of the product or economic cycle we see a boost to the feedback cycle as profits outpace sales up and down.  This is why most of us will lose in buying a “cheap” stock that is falling or shorting an “overpriced” stock that is rising…even if valuation does mean revert it may not be enough to offset the trending power of those profits.  As much as we internally hate the popularity of a rising stock we don’t own, it makes zero sense to stand against it because it’s “too high”…we rarely have any measure that can forecast what is too high or too low.  At the very least, wait until prices show signs of discounting future growth before acting on your beliefs.  The difference between shorting a popular growth stock with a trending stock and shorting a popular growth stock with a formerly trending stock is night and day.

I’m not good enough to cover this in 600 words, so I’ll use future posts to highlight tactics I use to embrace my personal wiring.  I’m no shrink, but I’ve found smoother success in accepting who I am, and figuring out how to properly use my inner contrarian while embracing the market’s propensity to trend.  There is a reason deep value and momentum, despite totally different tactics, remain consistent sources of alpha.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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