Reversion to the Mean Isn’t What It Used to Be

Reversion to the Mean

A lot of people look upon what has happened in the past to guide them in the future. Things have really changed in the markets though and some old ideas don’t work so well now.

The principle of reversion to the mean has been one that a lot of analysts and investors have followed faithfully for a long time. This goes back a very long way and when we’d see a stock, a sector, or even the market pull back or become what we considered to be overvalued, we would see this as an opportunity and look to sit in positions that we felt should come back based upon it being worth more than its current price in our minds.

This included not only looking to buy bottoms in the market itself, but to buy what we considered to be undervalued stocks as well as undervalued sectors, groups of stocks in a particular business category in other words.

As it turned out, the market itself thought that way as well at one time, to some extent anyway, meaning that we would see a certain opportunity for a reversion to the mean, and others would as well, enough to make this assumption a reality. If enough people think that something is underpriced and they buy it, that alone will put the price up and allow us to ride the wave upward that ensues from this.

Whether or not this ends up happening, and to what degree this strategy succeeds or fails, is therefore up to the market, but if we look to the past and see these things working fairly well, and look to anticipate a move like this, we’re going to have to be careful to keep our analysis relevant and not look back to a time where this thing may have worked out pretty well in the old days but not so much now.

The approach we need is a lot like the one that we use in technical analysis, and reversion to the mean can be used with both fundamental and technical analysis, but what we’re referring to right now is using it with fundamentals. The reversion to the mean here is between these fundamentals and prices, in other words between fundamentals and technicals, where these technicals are based upon price itself and not where we think it should be.

Price Trends Are the Real Benchmark Even Though We May Pretend Otherwise

Technical analysis is based purely upon price data, but we cannot give price data from different periods the same weight, because the more proximate data needs to be weighted more heavily. In other words, what’s happened more recently counts for more than what has happened further back in the past.

If we seek to use fundamental analysis properly, we’re going to have to do the same thing, and be particularly aware that situations change over time and what may have worked pretty well in the past may not now, or even anymore.

This principle is valid regardless of the time period or era that we are in, although the markets of today are a lot different than they used to be, and if we’re trying to use old ideas from the past and apply them to the current markets, we have to be particularly careful to adjust our ideas to meet the new frontier we are in.

Fundamental analysts aren’t so quick to do this, as their strategy is a more principled ones, using things like the principle of the reversion to the mean for instance and relying on something that has been relatively unloved to see that love come back in time.

It’s been quite a while since using reversion to the mean with fundamental analysis has been a good idea, but even fundamental analysists eventually end up seeing the light after enough time, and we’re seeing that some are starting to get this.

Using this approach may not have been so terrible when we would see a sector like telecom stocks give up a lot and then have investors come to their rescue and prop them up, but this is not the way of today and hasn’t been for quite a while actually. What happens when we use this approach wrongly is that we pursue positions that are underperforming and hang on to them as they continue to underperform, like the telecom sector for example.

It doesn’t matter what we think should be happening with stocks if our beliefs don’t translate to what actually has happened and is happening, and this is why it’s not a good idea at any time to be too presumptuous with our investing ideas. Even if we presume correctly, it is only when things actually move our way that we end up being right, and therefore there needs to be two components to this strategy, the idea and seeing the idea at least start to show that it will work.

Whenever we see a disparity between price and what we consider what the price should be, which is what fundamental analysis seeks out, acting on our beliefs will require at a minimum that they be tested, and tested with recent data and not what used to happen in the old days.

Fundamental analysis does have its use, but only in this context, and all of our assumptions need to be put to the test this way to even see if they are valid or are still valid. We also need to realize that to the extent this may work, it will always be completely a matter of whether or not our analysis actually does get acted upon by the market, for instance people seeing a stock undervalued in our minds and then jumping on enough so that outperforms other options.

This is not the way fundamental analysts understand these things though, as they seem to believe in some invisible hand conducting these reversions to the mean, bringing what is low higher and bringing what is high lower so that stock prices end up representing business conditions in a more standardized way.

This ends up being like believing in Santa Claus though, and when Santa doesn’t bring you presents for many years, you need to give up this belief. This was never a good belief actually, even back in the day when a lot more people traded on these things, because we then miss that it was their trading on this stuff that gave it life and did so in a variable manner that needed to be measured, not just assumed.

The Performance of Tech Stocks Trashed This Idea Completely

The boom in tech stocks that we see today are said to be responsible for changing this belief, and if analysts cling to their beliefs that these stocks remain overvalued, and their stock prices continue to rise in spite of this, they miss out on the moves. Instead, they may be stuck in other sectors who weren’t doing well at all at the time and are doing worse now, even though these are companies that are making plenty of money and trade at half of their earnings multiple than the hot stocks do.

While we might think that this doesn’t happen anymore and is a relic of the past, and we’ve come to accept the idea that reversions to the mean is an outdated concept, this idea still exerts considerable influence and the idea of value investing is far from dead, even though it is dying.

If the goal of investing in common stock was to earn dividends, if this was the exclusive goal that is, then this idea would make sense. Why wouldn’t we want to earn higher dividends with a so-called undervalued stock? As it turns out, dividends don’t matter much and only matter to the extent investors care about these things, and what they do care about more is capital gains.

Even earnings don’t matter fundamentally, and not mattering fundamentally means that the earnings themselves don’t have a thing to do with a stock’s price beyond their ability to influence people to pay more or less for the stock. People do pay attention to these things but when we have discrepancies between earnings and price, with two companies with similar earnings having their stock prices vastly different and even going in different directions, it does not even make sense to compare stocks that way as it turns out.

If we’re looking to flesh this all out more, it really comes down to a stock’s perceived outlook for the future. This is why the tech sector has done so well and a sector like telecoms has not. If we compare Apple for instance to your phone company, we see one company as on the cutting edge of the future with exciting possibilities and the other as being pretty dull indeed going forward.

This is not a recent phenomenon actually, and if we look back 20 years ago, Apple was trading at a little over $1 a share and AT&T was over $50. Today, Apple trades over $200 a share while AT&T is around $33. One company has seen its stock grow almost 200 times while the other is not up at all and has given back 35% over this time. The market was excited about the future of one, and not so excited about the other, and this all came to pass.

If we could go back in time, and compared the earnings of these companies at the time to their price, this would not have provided much insight at all and in fact this would not have spoken at all to what was to come in the next 2 decades.

If we had been sitting back all those years to see them revert to the mean, and bought and held both after the crash of 2000, perhaps waiting until 2003 when the dust completely settled from this and both stocks headed back up again, this approach would have had us quickly worried about Apple and we certainly would have been running to the exits as Apple’s stock grew 500% over the next 3 years.

We then would have put all of our money in AT&T which has gone nowhere since, and watched in horror as Apple went from around $5 a share in 2006 after these 3 years of gains to $200 in 2019.

This is an extreme example of course but is to show just how much the future does matter, and this can matter a great deal. This year’s projected earnings can shed some light on these prospects but if our view stops there, this is a lot like driving in extreme fog where you can only see a few feet in front of you instead of the whole road ahead which does need to be looked at.

If a company or a sector’s future is brighter, this will cause them to be overvalued in the present from a fundamental perspective, and the dimmer a company’s prospects are for the future, the more value they will seem to have. It turns out that this is all nonsense though, and some fundamental analysts are starting to get this more now when they speak of reversion to the mean being a dying concept.

What we really need to do when we get whatever fundamental ideas that we come up with is to make sure that these ideas do correspond with reality enough that we at least see the market starting to agree with us, and remain in these positions only as long as the market continues to agree. Whenever we and the market disagree, the market is always right and we will always lose.