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Google 'mean reversion,' I dare you. You'll get everything from the most complicated
academic mathematical studies to people claiming it's hocus pocus to those who swear it's the holy grail of investing.
So, just what is 'mean reversion'? Wikipedia defines it as "the assumption that a stock's price will tend to move
to the average price over time." But do you want an even simpler, more real-life example? OK, say a stock is at
$20, bad news comes out, and it goes to $10 over a few days. Is there an opportunity to buy it at $10, sell it at
$15, and reap a 50% gain? We think so.
Let's start at the top. The market overreacts to everything. If the news is bad, investors see the stock going to
zero. If its good news, they see the stock going to $10,000. And it isn't just concentrated to individual equities.
Look at some of the single largest market-move days on the S&P 500:
On September 29, 2008, the S&P 500 lost 106.85 points. That's a single day drop of 8.81%. Two weeks later, on
October 13, it bounced back with a 104.13-point gain, or 11.58%. If that wasn't enough of a recovery for you, the
S&P 500 added another 91 points, or 10.79%, on October 28.
Does everyone remember the technology bubble of 2000? Well, it reached a crescendo on March 16, 2000,
with a 66-point gain, still the third highest daily gain in the last 50 years on the S&P 500. This was followed
up by an 84-point decline on April 14, the third largest decline in the last 50 years. Both moves happened all
within one month.
Over the last two months, in our monthly white papers we have tried our best to debunk investing.
For investing is not that complicated—human emotions are.
In June, we wrote about "Time in the Market, Not Market Timing", which emphasized that, if you have a plan
and are patient and disciplined in your approach to investing, then money is virtually assured to be made.
Was there a difference between investing on the best day of the year and the worst? Sure. Was it enough for
someone to regret their decision? No way. The results were 8.82% vs 6.58% over 20 years. If you look at 10-year
rolling periods in the S&P 500, there are 80 points to review, and 75 of those 80 resulted in positive returns if
you had a 10-year time horizon. Those numbers dropped to 65 positive and 24 negative periods if your time
horizon was one year.
In July, we examined investor behavior and an investor's virtually perfect penance if acting on their own for
selling at the low and locking in a loss. We highlighted that the average mutual fund in a 10-year period had a
9% return while investors in those funds had returns of less than 3%, that fear was greater than greed, and that
nearly every investor feels that zero is in play when things turn south.
This month, we are discussing the finer points of investing and looking at where "select, measured" opportunities
could be taken advantage of from either an individual equity standpoint, or even a sector play, based on mean
reversion..
The above chart shows the performance results of 12 sectors within the S&P 500. Energy was the worstperforming
sector in 2014 and 2015, and then the best in 2016. Real estate went from third to last to first in
2012, 2013 and 2014. Health Care had a good run: second, third, and second again in 2013, 2014 and 2015,
and then last in 2016, and it's #1 YTD in 2017 (as of July 6, 2017). At WT Wealth Management, we believe this
epitomizes mean reversion.
Do we pick sectors based on this? Sometimes. It's simply one of the dozen or so tools we use to try to place
our investors in areas we believe have the best chance of success with, in our opinion, as little downside as
possible.
In short, nothing stays up or down forever. Often the biggest loser one year is the biggest winner the next, and
the biggest winner frequently becomes the biggest loser. That's the essence of mean reversion. A 5-, 10- or 15-
year chart makes it look like a smooth ride, but in reality it never is. Unforced errors and missed opportunities
present themselves every day. This harkens back to our incessant talk of having a plan and knowing your risk
tolerance and real objectives.
The same opportunities present themselves in the individual equity world almost daily, and especially around
earnings season. In our more aggressive accounts, where investors want speculation, we use a strategy of
buying when "blood is in the streets". Not a game for the faint of heart, mean reversion requires knowledge,
discipline and patience.
Consider Palo Alto Networks. (The chart is below.) Tech companies like Palo Alto trade based significantly on
earnings and earnings guidance. They also trade at high price to earnings (PE), which make them even more
volatile. Earlier this year it had one of those instances and fell from the $150/$155 range to $115 in a few trading
days. Then, by June, good news surfaced, and the stock rallied back to the mid $130's.
Does it always work like this? Heck no. It could take you months or years to capture your return. Again, as I
stated earlier, mean reversion is one of a dozen tools we use for trading individual equities. In this case, we did
buy Palo Alto under $112 and sold half our position above $135, a nifty 20% gain on that trade.
It should be no secret—investors, speculators and trades overdo everything. Nothing is as bad or as good as
we all would be led to believe.
Mean reversion is a real tool on both the upside and the downside. It's one reason why we at WT Wealth
Management constantly fade winners by selling and taking profits. It's also a reason why we may be buying
stocks on a day when people question our sanity. Human nature is funny. Many people would feel better
buying a stock that had gone from $10 to $20, than from $20 to $10.
Read that last sentence over and over again. It's human nature at its best—or maybe its worst.
WT Wealth Management is a manager of Separately Managed Accounts (SMA). Past performance is no indication
of future performance. With SMA’s, performance can vary widely from investor to investor as each portfolio is
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