Last Update: August 2021

One of the most powerful forces in the world of Wall Street is mean reversion. Its influences have been felt since the beginning of the market, and rest assured, it will be here until the bitter end. Sometimes it may look like mean reversion is dead, but it’s not. It’s merely playing possum and shall return at a most inopportune time (for most) to remind the denizens of the Street that it can’t die. And it’s a force you forget to your own peril.

In today’s missive, we’ll explore mean reversion in-depth. After fleshing out its definition, we’ll take a look at how it manifests itself in everything from technical and fundamental analysis to volatility.

Definition

The simplest way to wrap your head around the concept of mean reversion is to break up the phrase and define its constituent parts.

First, we have the mean. In explaining this component, we merely need to take a trip down memory lane.

Let’s go back; way back for some of you more <ahem> seasoned readers.

Okay, that’s far enough: elementary school. Grade four, to be exact. There you are perched at the edge of your seat, number 2 pencil in hand, a budding pupil digesting the magic of math.

Today’s topic is collecting, organizing, and analyzing data. Specifically, how to calculate the average for a set of numbers. Here you discover the concepts of mean, median, and mode.

Jostle your noggin a touch to shake the cobwebs off and you’ll likely remember the definition of these three words.

Mode is the number that occurs most often in the data set. Median is the middle digit of the data set if the numbers are placed in order from least to greatest.

Mean is simply the average. To calculate it, just add up all the numbers and divide the sum by the number of numbers. Yes, I could have worded that better, but where’s the fun in that? Number of numbers has a nice ring to it, no?

So, mean is another word for average.

Now, on to the second part of the phrase: reversion. I’ve racked my brain for a telling tale of how you discovered the concept of reversion, but alas: my thinker is failing me this morning. So let’s keep it simple, shall we?

Here’s what Merriam-Webster has to say about the word:

Reversion: an act or process of returning to an earlier condition or state.

Merriam-Webster

Mean reversion, then, refers to the tendency of something (i.e. stock price, P/E ratio, volatility) to continually return to some average level over time.

Let’s see how this plays out in your beloved price charts again and again.

Technical Analysis

Think about the behavior of any stock you’ve been following recently. What happens when it rises too far too fast? It comes down. What happens when it falls too far too fast? It comes back up.

That’s mean reversion at work!

In trying to identify the mean level that a stock price should revert back to at some point, try using a moving average. After all, they are designed to reflect the average price level over time. Since the moving average is updated daily, it stays relevant.

For example, short-term traders might use the 20-day moving average. When a stock deviates too far from the 20 MA, it’s a good bet it’s due for some mean reversion. This is the dynamic we rely on when looking to short an overbought stock or buy an oversold stock.

Consider the following chart of AAPL (click to enlarge) with the 20 MA in red. At point 1 the stock had been rallying higher for a couple weeks distancing itself from the 20 MA aggressively. Finally, mean reversion exerted its influence pulling the stock back towards the 20 MA.

Point 2 illustrates the same dynamic in the other direction. AAPL’s price fell aggressively, deviating far from the mean. Traders looking to exploit the reversion would be eyeing AAPL for a bullish trade here.

Though most traders focus on trading with the trend, mean reversion helps create some interesting counter-trend setups. The most compelling times to short an uptrend are when the stock is so overbought that betting on mean reversion becomes a lay-up. The same could be said about buying downtrends in extremely oversold situations.

Fundamental Analysis

As we lengthen our time frame, fundamental metrics become increasingly relevant. The Buffets of the world are fundamental analysis die-hards in part because their hold times range from multiple years to, well, forever. If you’re going to invest in a company for the long run, then it’s certainly worth looking under the hood to make sure you’re confident with their business model and current valuation levels.

Day and swing traders typically care little about this approach as they are long gone before any type of major shift in the company’s fundamental health transpires.

Regardless of your trading style, it pays to learn how mean reversion manifests itself in the world of fundamentals. It will provide a better grasp of long-term cycles, and whether or not you use it, millions of others do. The metric of interest to us today is the price-to-earnings ratio (aka the P/E). I introduced it in my weekly article last month called Inflation: The Hidden Driver of Stock Prices, but a brief review is in order.

To calculate the ratio, we simply take the current price of a stock and divide it by the annual earnings per share for the company. For example, if XYZ company is trading for $100 and earned $10 per share over the past year, its P/E ratio would be 10. In other words, XYZ is trading for 10 times earnings.

Stock watchers use the P/E ratio to gauge the current value of the market. When you hear the chattering class talk of the market being overvalued or undervalued, they’re typically referring to the current P/E of the S&P 500 Index.

Since the S&P 500 is a basket of 500 companies, the earnings for the index is essentially the cumulative earnings for every company in the bucket. For example, the S&P 500 just closed at $2091 and according to Factset, the forward 12-month earnings per share currently stands at $127.40.

Put it all together and you’ve got a P/E ratio around 16.5 right now.

So how does mean reversion enter the equation?

Well, take a look at the following chart illustrating the P/E ratio of the S&P 500 from 1929 through last year. Notice how it tends to oscillate in somewhat of a range? Chalk that up to mean reversion. Periods of high P/E ratios have been followed by periods of low P/E ratios. If you look at the past 25 years, a fair time frame representing modern markets, the average P/E ratio is 18.90.

If you’re lucky enough to dive into the market when P/E ratios are depressed, your average expected annual returns going forward are higher. Alternatively, if you’re plowing in when P/E ratios are in the nosebleeds, your average expected annual returns going forward will be lower. This explains why long-term investors with an eye toward fundamentals are hesitant to put new money into the market when valuations are sky high.

One of the ultimate culprits for mean reversion in the land of valuation is human emotion. During bull markets, the investing masses turn giddy chasing prices to higher and higher levels. P/E ratios climb as the steep rise in prices outraces the actual increase in corporate profits. This disconnect can only last so long. At some point, the exuberance wears off and the number of greater fools dries up.

Then the process reverses.

As a bear market takes root pessimistic investors jettison shares from their portfolios causing prices to sink. Provided prices fall faster than any type of decline in profits, the P/E ratio recedes back to some average level – usually undershooting on the downside.

Rinse and repeat.

Volatility

The pull of mean reversion is arguably most potent in the land of implied volatility. It’s a phenomenon that option sellers rely on time and again to both spot and exploit opportunity.

Option prices are driven by a number of variables including stock price, strike price, and time among others. When you first learn of option pricing models, it can seem like options are simply priced by a machine using hard, cold math.

The problem with this visual is it completely omits the human element.

What of supply and demand? Isn’t the price of any good in a marketplace set by these twin forces? If demand for pineapples outstrips supply prices rise. If the supply of milk is higher than demand prices fall.

So how do we measure these dynamics in the options market?

With implied volatility.

Think of implied volatility as the tool to gauge demand for options. When demand rises, option premiums increase driving implied volatility higher. When demand falls, option premiums shrink driving implied volatility lower. At some point, implied volatility becomes so high that demand dries up and sellers enter the market to take advantage of the now expensive options. On the flip side, at some point implied volatility falls so low that sellers dry up and buyers enter to snatch up options on the cheap.

This is why volatility exhibits mean reversion. And it explains why high implied volatility is such an attractive opportunity. It’s not a matter of if it will go down, but when.

Notice how the accompanying chart of implied volatility is somewhat range-bound. The mean is a magnet that becomes stronger the further volatility deviates from it.

Bottom line: mean reversion is a force to be reckoned with. It plays a part in all forms of analysis. Understand its influences and embrace them to profit.

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