Reversion to the Mean.....

"Many shall be restored that are now fallen; and many shall fall that are now in honour"
(Horace: Roman Poet. Published in 18 B.C.)

On 3-Sep, 1929, the Dow Jones Industrial Average touched a high of 381.17. It touched a Great Depression time low of 41.22 on 8-Jul, 1932. The Dow returned to its pre-Depression value again only in 1954. The BSE Sensex was quoting at 20873 points in January 2008. In March 2009, the Sensex touched its crisis-time low of around 8100 points. The Sensex has recovered most of its losses and, it is now heading towards 18000.

An old Persian saying goes, "This too shall pass". How many investors had the experience and the equanimity to step back when valutations got over-heated in January, 2008. How many of us had the courage to re-enter in March, 2009? An awareness of Mean Reversion might have at least sown a seed of doubt and prompted us to act. We may not have been able to time our moves exactly, but we might not have been blind-sided by the sudden upheavals in the market.

Over the 80 years between the Great Depression of the 1930s and the late 2000s recession, developments in economic research have helped us to reduce the intensity and duration of major economic upheavals. However, the economics profession still hasn't been able to resolve the fundamental problem - how to prevent bubbles in the first place. In fact, economists even disagree about the desirability of preventing bubbles from inflating. One school of thought suggests that limiting bubbles stifles innovation. Exhibit 'A' in their argument? Would the huge investments in communication bandwidth and infrastructure have taken place if not for the dotcom boom?

It seems clear that for the foreseeable future, investors will have to keep a cautious watch to ensure that we donot get caught up in bubbles. An understanding of 'Mean Reversion' will keep investors aware and alert at all times for potential storms coming our way.

As a statistical concept, Mean Reversion (also known as Regression to the Mean) is defined as follows: "A variable that is extreme on its first measurement will tend to be closer to the centre of the distribution on a later measurement". This has been observed in a remarkable array of physical and biological phenomena. Mean reversion is also observed in financial markets, which are nothing but collections of biological actors (Automated trading algorithms would perhaps qualify as Physical actors? But we will leave that discussion for another day.)

An adaptation of this concept to the field of investing might read as follows: Any investment that delivers exceptional returns during one period of observation is highly likely to deliver lower than average returns during the next period of observation, and vice versa. This phenomenon has been observed in different markets and at various levels of granularity. For instance, Emerging Markets as a category delivered exceptional returns during the 2003-2007 boom. However, they under-performed to a greater extent than developed markets during the financial crisis. Small and mid cap stocks out-performed before the crisis and vice versa. Fixed Income securities under-performed during the boom (which is to be expected in rising interest rate environments). However, during the rapid interest rate cuts initiated by central banks around the world to stem the crisis, fixed income funds outperformed. This applies to individual stocks as well. For instance, many stocks which were listed during the last stages of the boom and delivered huge post-listing gains, went through catastrophic drops over the past few years, and have still not recovered.

Wise investors with enough experience of the markets are aware of this phenomenon, and tailor their investment decisions accordingly. On 17 October, 2008, in the aftermath of the crash of Lehman Brothers and with the world economy looking as if it was at the edge of collapse, Warren Buffett wrote an editorial in the New York Times, in which he made a bullish buy call on the US stock markets. He wrote that he was personally buying stocks of blue-chip U.S. companies and advised other investors to do the same. On the day, he issued his call, the S&P 500 closed 940. The latest quote on the S&P 500 is currently quoting at 1187, just 150 points below its peak in January, 2008.

Booms and Crises cannot be predicted with any regularity. But the next time investors hear the phrase "Its different this time" to justify the latest boom, they would be well advised to remember 2 words - "Mean Reversion".

- Vivek Iyer, Equity Research Analyst, HBJ Capital Services Pvt Ltd, [Vivek@hbjcapital.com]