October 2013: Reversion to the Mean

October has arrived and the excitement is palpable in the Bootstrap household.  A burning question needs to be answered in the next several weeks: What is Quinn going to wear as a Halloween costume? Last year we lived in a neighborhood with very few families, but this year we live in family friendly Willow Glen. We expect a veritable onslaught of sugar-crazed kids at the door.  Colleen is so excited she can hardly contain herself.
 
I think everyone knows how I feel about Fall.  Since the pace is a little slower this season, I thought I would take some additional time to write about one of the core investing concepts I think about at Bootstrap Capital.  It’s called Reversion to the Mean…
 

Reversion to the Mean: It’s not a Coldplay song 

I think one of the best analogies for the stock market is that of a pendulum.  Rather than butcher the analogy on my own, I thought I would borrow liberally from Howard Marks.  He is the Chairman of Oaktree, a very successful distressed debt investor and insightful writer.  Here’s his description of securities markets:
 
“The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum ‘on average,’ it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back.
 
Investment markets make the same pendulum-like swing:
 

• between euphoria and depression,
• between celebrating positive developments and obsessing over negatives, and thus
• between overpriced and underpriced.
  

 
This oscillation is one of the most dependable features of the investment world, and investor psychology seems to spend much more time at the extremes than it does at a ‘happy medium.’” – Howard Marks, Trust Company of the West, Q1 Letter 1991
 
A picture of the pendulum concept looks like this:

Although less regular and periodic, the stock market exhibits the same type of reversion to the mean tendencies:

Weekly S&P 500 Data from Yahoo Finance; 1/3/1980 through 9/16/13; includes dividends; log scale
 
As you can see from the chart above, the price of the S&P 500 has spent very little time on the actual trend line.  It is usually above or below, sometimes by a very large margin.  Like a stretched rubber band, the further away from trend that the price drifts, the harder it snaps back when it changes direction.   
 
There are many common aphorisms that relate to reversion to the mean: “trees don’t grow to the sky”, “what goes around comes around”, “what goes up must come down” and my personal favorite, “It’s always darkest before the dawn”.  I assume the reason there are so many ways of saying the same thing is because it’s such a common theme in life.
 
As a little mental exercise to demonstrate the extremes of this, let’s think about the performance of the stock market since 1970.  The average long term total return as measured by the S&P 500 is commonly cited as approximately 10%.  Can you guess how many times the annual return of the index could be rounded to 10% (i.e. from 9.5% to 10.5%)?  No cheating now.  The answer is one: 1993 at 10.08% (the next closest is 2004 at 10.88%). 43 years and only one was average! Don’t take my word for it, you can find the data here. 
 
Although reversion to the mean is a core concept to keep in the back of your mind, I would not recommend using it to try to forecast market turns or engage in market timing.  There is no identifiable trend as to how long the swings can last; unlike the pendulum, swings in the market are not regular.  In fact, if you look at the chart above, you might think we are due for a long period of above average returns while we catch up to trend.  But if you change the time horizon a bit, you end up with this picture:

Weekly S&P 500 Data from Yahoo Finance; 11/2/1998 through 9/16/13; includes dividends; log scale
 
Suddenly, where we are in the cycle looks a lot less clear.
 
If reversion to the mean cannot predict the turns in the market, what good is it? While it’s not predictive, it is a wonderful way to help manage our expectations.  After a period of market advance it is natural to expect a reversal of direction. And, as investors we should not be surprised - we should be prepared for this to occur. 
 
Next quarter, we will look at reversion to the mean and how it works with asset allocation to power our long-term investment strategy.  In the meantime, if you have any question about reversion to the mean or any other investment concept, don’t hesitate to contact me.  Also, if your friends or family have questions about any investing or any financial issue, please feel free to make an introduction or forward this letter.  We provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances.  We will treat your friends and family with the same care and diligence that we treat you.
 
Take care,

Brian McCann, CFP®