SMSFundamentals: Leveraging Mean Reversion For Decisive Investment Returns

SMSFundamentals | Jun 12 2024

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Leveraging Mean Reversion For Decisive Investment Returns

While making investments, volatility can be considered an ally. To derive considerable returns with safety, there exists a principle: mean reversion. Similar to gravitational force, it pulls asset prices back to equilibrium.

For sharp investors, understanding mean reversion is an essential element. The article focuses on the core of mean reversion investing. Overall, when disciplined and logical entry-exit strategies are applied to market ups and downs with precision, they yield favourable returns.

-Mean reversion investing capitalises on the tendency of asset prices to return to their historical averages over time
Core aspects include moving price averages, valuation multiples, and trading indicators for systematic application
Risks include reliance on historical data, fundamental weaknesses in assets, and failure during extended market trends
Real-time application involves careful asset selection, confirmation of time frames, and the formulation of clear entry and exit strategies

By Anuj Sharma

Figure 1: Mean Reversion Marks Extreme Long-Term Opportunities on S&P500

Understanding Mean Reversion Investing

Simply put, mean reversion investing suggests that asset prices tend to revert to their historical average or mean over the specified time. This approach capitalizes on the statistical rationale that extreme deviations from the mean are temporary and will eventually correct themselves toward the dynamic mean.

For instance, if a particular stock experiences a considerable increase in price due to market speculation or hype (like AI), mean reversion investors might anticipate that the price will eventually decline back to its moving average. One would then sell the stock to exit the position or apply other strategies (buying put options) to derive profit from this anticipated decline. 

Similarly, in commodities, if the price of crude oil spikes due to geopolitical tensions (conflicts) and OPEC+ cuts, mean reversion suggests that the crude oil price will revert back to its moving average once the tensions subside (peace talks) and increased OPEC+ production.

Figure 2: Crude Oil Futures During October 2023

Figure 3: The fluctuations in Crude Oil futures price during Israel-Hama conflict in October 2023, reverting back to the 65-Day (3-months) mean. 

To comprehend a sharp and easy execution of mean reversion strategies, investors can focus on simple quantitative factors, such as asset price, valuation multiples, and/or technical indicators, to identify assets that have deviated considerably from their historical means. With that, they then enter positions with the expectation that prices will revert to the mean, and derive returns from the ensuing correction. 

The Core of Systematic Mean Reversion Investing

At the basic level, three core aspects form the basis of systematic mean reversion investing: the state of price average, valuation multiples, and trading indicators.

Historical Price Average: 

This aspect assesses an asset's current price relative to its historical average. One has to configure the moving averages over specified time frames to identify deviations from the mean and take action accordingly. For instance, a 156-week moving average compared to the current price can signal whether the asset is overbought or oversold from a mid-term perspective (52 weeks per year * 3 years). For instance, if the ASX200's price is trading well below its 156-week moving average, one might interpret it as undervalued and buy systematically, expecting the price to revert upwards.

Valuation Multiples: 

Similarly, this aspect measures an asset's price relative to fundamental performance metrics such as earnings, sales, or cash flow. Basic valuation multiples include the price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and price-to-sales (P/S) ratio. When these multiples diverge considerably from historical averages, it may indicate mispricing. For instance, if a stock historically (5-year average) trades at a P/E ratio of 17 but is currently trading at a P/E of 11, it can be considered undervalued and expect the price to revert upwards to hit its long-term average mark.

Trading Indicators: 

Finally, this aspect employs technical indicators derived from price and volume data to identify potential reversal points. Like the Relative Strength Index (RSI), Stochastic Oscillator, and Moving Average Convergence Divergence (MACD). These indicators assess the momentum and strength of price movements. When an indicator signals that an asset is oversold or overbought, investors may anticipate a reversion to the mean. For instance, if the RSI indicates that a stock is overbought (RSI > 70 and >Regular Bearish level), it can be seen as an opportunity to book profit (exit) on a long position.

Figure 4: Commonwealth_Bank (Moving Average + RSI)

Figure 5: Commonwealth_Bank (Price-to-Book Ratio)

Downsides and Risks

It's critical to note that mean reversion investing carries risks, as prices may not always revert as expected, leading to extended losses if the trend persists.

Fundamental Issues with the Asset: 

One considerable risk is relying on historical price averages, valuation multiples, and trading indicators that may generate false signals for an asset that is already attached to considerable fundamental weakness. For instance, a company’s stock may appear to be undervalued based on moving averages, PE, and RSI, but underlying fundamental weaknesses (like loss of competitiveness, lack of liquidity, inefficient capital structure, and regulatory adversities) could prolong its deviation from the mean, leading to losses on long-term positions.

Market Trends Override: 

Mean reversion strategies may fail during extended market trends, such as prolonged bullish or bearish market sentiment (like the current AI hype environment or boosted performance). In such conditions, stocks may continue deviating from their moving averages for an extended period, resulting in losses while attempting to capitalize on mean reversion.

Figure 6: Nvidia (Moving Average + RSI)

Figure 7: Nvidia (Improving Price-to-Earnings Ratio)

Step-By-Step, Real-Time Application of Mean Reversion Investing

Identify the Mean Reversion Candidate

The asset (especially stocks) for mean revision should be fundamentally resilient and solid to avoid or minimize the downsides and risks. Here, regular critical assessment of the stock’s performance, the company’s operational and financial trends, and the industry and macro environment is a must. For long-term consistency and to avoid stock-specific risks, an index, or ETF, can be selected. The same applies to commodities, forex, and alternative assets (like crypto). 

Confirmation of the Time Frame 

The selection of the time frame (for moving averages) usually depends on the investment horizon or frequency of traction one is looking for. For instance, if the investment horizon is 5 years, then 260- weeks is a suitable time frame for the application of mean reversion. However, if the investor is looking to establish a long-term position systematically (based on annual frequency or dollar cost average), a 260-days moving average can be applied with a 260-week moving average. 

Strategy Formulation

To set clear rules of entry and exit, the proper configuration of moving average, valuation multiple, and technical indicator should be established. For instance, the rule of entry can be when the price is below the 260-week moving averages, with PE multiples below the long-term average and RSI below 30 and a regular bullish level. The rule of exit can be when the price is above the 260-week moving averages, with PE multiples above the long-term average and RSI above the regular bearish level and 70. 

Figure 8: ASX 200 (Moving Average + RSI)

Figure 9: ASX 200 (Forward PE Ratio)

In conclusion, mean reversion investing is a disciplined approach to capitalising on market cycles and fluctuations.

By leveraging historical averages, valuation metrics, and technical indicators, one can capitalize on market volatility with precision. However, it's vital to be aware of the downsides attached to this strategy.

Through well-assessed asset selection and systematic application, a mean reversion strategy can yield favourable returns.

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