A Reversion to the Mean

April
15

Written by: Jon McGraw

Last week, the term ‘Easy Money’ conjured both comedian Rodney Dangerfield and the U.S. Federal Reserve, and no one was certain how much respect either one should get.

The Fed accidentally e-mailed its market-moving Federal Open Market Committee (FOMC) meeting minutes to congressional staffers and trade lobbyists on Tuesday at 2 p.m. The minutes weren’t supposed to be released to anyone until Wednesday at two. Once the mistake was realized, the Fed released the minutes early on Wednesday morning.

Markets enthusiastically embraced the minutes which appeared to focus on the idea quantitative easing will continue. The Dow Jones Industrial Average closed at a record high more than once last week, and the Standard & Poor’s 500 Index is already nearing analyst’s targets for the full year.

The minutes indicated committee members were less clear on the issue, according to the Washington Post, which reported:

“A few Fed officials think QE (Quantitative Easing) should be stopped immediately; a few think it should be shrunk fairly soon; many think it should be slowed if we see a rebounding job market; a few think it should continue at its current size until the end of the year; and a couple think it may need to be increased. The minutes also make clear Fed officials are not all on the same page in determining the economic climate that would trigger that tapering.”

Committee members are not the only ones who don’t know what to think about the economy. Consumer sentiment has been volatile. According to The Wall Street Journal, the Thomson-Reuters/University of Michigan consumer sentiment index showed consumer sentiment improved significantly from mid- to late-March only to decline again from late-March to mid-April. Bloomberg.com speculated weaker consumer sentiment may have been the result of the payroll tax roll and weaker U.S. economic data.

Data as of 4/12/13

1-Week

Y-T-D

1-Year

3-Year

5-Year

10-Year

Standard & Poor’s 500 (Domestic Stocks)

2.3%

11.4%

14.5%

9.9%

3.7%

6.0%

10-year Treasury Note (Yield Only)

1.7

N/A

2.0

3.9

3.5

4.0

Gold (per ounce)

-2.1

-9.3

-8.0

9.8

10.6

16.8

DJ-UBS Commodity Index

-0.2

-3.8

-5.3

-0.2

-8.7

1.8

DJ Equity All REIT TR Index

2.6

12.8

24.1

17.6

7.7

12.7

 

IT HAS BEEN SAID STOCK MARKET RETURNS REVERT TO THE MEAN

But what does that mean? Reversion to the mean is a statistical phenomenon. It’s the idea the further something is from the mean – or average – the more likely it is the next thing that comes along will be closer to the mean. For example, if a baseball player has a batting average of .330 and hits .180 in a game, it’s likely that player will hit better in the next game (unless, the player’s in a slump, but that is a different topic).

Reversion to the mean is the theory behind a variety of investment strategies. Analysts who employ the theory may look at an average price, an average return, or another financial statistic they find relevant. For example, they may consider whether a company’s recent performance varies significantly from its historical average performance. If its performance is worse than average, some analysts may decide the company’s price is likely to revert to the mean. In that case, they may choose to invest in the company. If the company’s performance is better than average, analysts may decide to sell shares. Similarly, if a market or index – such as the U.S. Treasury market or the Standard & Poor’s 500 Index – performs significantly worse than its mean, investors may decide better performance is ahead, and vice versa.

In 2009, an article in Forbes stated, “Mean reversion is an odd concept because it’s clearly not causal. The market’s historic return of 9 percent a year is based on over 100 years of data (what’s typically considered the modern stock market), and, of course, the ride to 9 percent is a bumpy one with major double-digit up years and big double-digit down years all averaging to that 9 percent number.” The point is any average is a moving target. After all, a significant downward movement pushes the historical mean lower and a significant upward shift pushes it higher.

Regardless of the investment theories employed by analysts and money managers, investors may want to set financial goals, carefully choose asset allocation strategies, hold well-diversified portfolios, and maintain their long-term perspective.

Weekly Fun – Third Friday Art @ Kansas City Club

“Above & Below – Photography by Ben Gasser” 6pm to 9pm April 19th

Ben is a lifelong resident of the Kansas City metro and has been capturing the city and suburban views in photography from a high perspective atop local buildings and also focusing on the details below. Both perspectives are presented in this solo exhibition.

Appetizers & drink specials. Chef Joe creating an amazing “Above & Below” dinner.  More here.