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On Mean Reversion

Michael-Gayed-sepiaBy Michael A. Gayed CFA
[Portfolio Manager]

Mean reversion is perhaps the one and only constant when it comes to markets and life.  Mean reversion is as old as the Bible – he who is first shall be last, and last first.  We go from 75-degree weather on Christmas day, to one of the most historic blizzards on the east coast ever nearly a month later.

Somehow, nature (and markets) return to balance by moving from one extreme to the other. Mean reversion is dependable, but tough to remember when living in the extreme.  This is so because it is hard to imagine that everything can change in the not-too-distant future.  When dealing with markets, study after study concludes that if you take the worst performing asset classes, country indices, or strategies over the last three years, the next three years tend to be very good ones.

Fund Flows

Yet, in looking at fund flows for those areas, inevitably most exit those investments towards the tail end of that cycle which did not favor those particular investments. With volatility on-going, it is worth asking if we are on the cusp of a mean reversion moment in quite literally everything.

The iShares MSCI Emerging Market ETF (EEM) is down 8.8% year to date, with the iShares China Large-Cap ETF (FXI) down 12.92%.  Looks like a crisis, until you look at the performance of the US iShares Russell 2000 ETF (IWM) which is down 9.98%.  Emerging markets more broadly are actually down less than the average small-cap US stock despite continuous hammering of the idea that a global slowdown and fears over China are the source of market volatility. The narrative lags reality, no different than how money flows lag in response to changing cycles.

The real blizzard in 2016 is one of significant mean reversion

There are major investment themes which can change this year.  First and foremost is the theme of passive over active.  For the past several years, passive investment vehicles have been all the rage as ETFs of every stripe came out, allowing for more index allocation options.  Indeed, indexing can be a strong strategy, but what is forgotten is that as more money goes into passive strategies, the less money there is taking advantage of active anomalies and opportunities.

Mean reversion here suggests that we may be entering an environment where passive investors don’t perform as well as they had, as new momentum opportunities and risk-off periods allow for tactical trading to really shine beyond the small sample. Whether stocks have bottomed or not is irrelevant for now.

The greatest opportunities will come from 1) avoiding or minimizing the impact of more frequent corrections in stocks (not one week extremes like the start of 2016), and 2) positioning in reflation trades through commodities and emerging markets which have been left for dead as being investable.


Bell Curve


Should mean reversion begin to take hold this year, betting against those areas can result in significant loss.   Investors in those areas now are suffering and doubting their investments, which may be precisely why tremendous money can be made.


As 2016 unfolds, we will continue to address these potential opportunities in our writings (click here to read).  The thing about the future is that it’s hard to predict what happens next…except at extremes.


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One Response

  1. Why I Don’t Pick Stocks

    Between 2000 and 2002 I worked as head weather derivative trader at PG&E National Energy Group. On the side, I also traded stocks for my personal account.

    By the time the Enron Debacle happened, I had already become the third largest weather derivative trader in the country. Given another year, I am quite sure I would have become #1 in this field. Well, that’s a story for another time.

    My stock trading, however, was a lot less successful. All the stocks I picked lost money, except for one. The one exception was PCG, the company I worked for. Granted, the time between 2000 and 2002 was a time of market collapse due to the burst of the dotcom bubble, but there is still an important lesson I learned and that I want to share with you.

    The lesson was about information advantage

    Though I was not in management and therefore was not privy to any material insider information, just from the ambiance noise of the trading floor I know so much more about my company than folks outside of the company. That’s why I was able to make money on PCG. That’s also why I didn’t make money in all those other stocks – I didn’t have any information advantage. In fact, by trading those other stocks, I made myself available to be taken advantage of by people who had stronger information.

    I highly recommend against stock picking with maybe the exception of the company you work for. Even there I counsel caution. I know a senior exec who worked for MCI WorldCom and all his investment was in MCI WorldCom. When the company went under, all of his wealth was gone like a puff of smoke.

    My rule of thumb is no more than 20% of your portfolio should be in the company you work for. Even though you may know your company better than others, let’s face it, you don’t know what you don’t know.

    Michael Zhuang
    [Principal of MZ Capital Management]


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