Reversion to the Mean

Heather Cullen

Heather Cullen

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In The Money

Heather Cullen Blog IN The Money Reversion to the Mean

Reversion to the Mean.

I was reading ‘The Little Book of Commonsense Investing’ and it was espousing ‘reversion to the mean’ – in other words, over time stocks will ‘revert’ to their trend. So, if the stock has been going up and then starts to go down, don’t worry, it will eventually return to its uptrend.

Well, good luck with that!   No wonder there are so many temporary traders.

What reversion to the mean means

It’s a statistical concept, where extreme values are likely to be followed by values that are closer to the average.

For example, two very tall parents are likely to have a child who is shorter than they are. But this is where we are drawing from a population which is bounded and predictable. No adult human has a height of more than, say, 5 meters tall, or less than 5 cm.

Stock charts are time series

Where people come unstuck is applying this concept to the stock market. A stock’s price is not bounded on the upside; it can reach lofty heights like Berkshire Hathaway or reduce to zero like Lehman Brothers.

Reversion to the mean cannot apply to stock charts as a stock’s price is a time series, and reversion to the mean does not apply to time series. Yes, it can apply to normalised measures like EPS but not to a stock chart.

Mean reversion cannot be applied to time series

Much as traders would like it to be, it is not a valid application. Unlike independent observations of, say, human height, time series points are dependent on past value, but also they are influenced by trends, cycles and other factors. Hanging onto a stock that is going down is and exercise in hope against reason – but people do it. Needless to say, I didn’t bother finishing the book.

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A decent job? Thanks AI. I am flattered. Not.

To the markets

Some big waves last week. After the NVIDIA results you would imagine the market was going up. Well,  I thought so, and it did for the first hour or so. I went to bed thinking I was going to wake up to a nice surprise in the morning. Alas, no. The market had dived overnight. It was a surprise, but not the one I was hoping for. Luckily on Friday the market saw the error of its ways and bounced up again. Lets see what actually happened:

SPY Charts

You can see Thursday’s ominous red candle. Nasty. On Friday, it was an ‘inside day’, where the trading was all contained in the trading range of the day before. My guess is that we are going to have a period of consolidation before another move upward – but that’s all it is, a guess based on what usually happens. 

I don’t know what is actually going to happen – and neither does anyone else.

Heather Cullen Blog IN The Money Reversion to the Mean

The weekly chart shows that the upward trend has resumed  after a rather large bear trap.

SPYG Charts

SPYG is  showing the same patter as SPY, with an inside day on Friday, although Thursday’s bearish candle was not as large. Possibly, SPYG is going to enter a period of consolidation. Or not!

Heather Cullen Blog IN The Money Reversion to the Mean

We can  see that it has well and truly broken through resistance and is making new highs.

QQQ Charts

Like SPY and SPYG, Thursday was a nasty bearish candle, and Friday an inside day. Given that the last consolidation period lasted months (Feb – April) we could be in for a boring time. Maybe. Maybe not.

Heather Cullen Blog IN The Money Reversion to the Mean

The weekly chart shows that the bear trap has ended and the upward trend has resumed, and QQQ is making new highs.

Heather Cullen Blog IN The Money Reversion to the Mean

VIX Chart

The VIX continues to be in very low volatility territory. Let’s hope its a few months to its next blip.

ITMeter

Heather Cullen Blog ITMeter

The week ahead . .

It is a shortened trading week; Monday is the Memorial Day holiday. On Friday, the PCE (Personal Consumption Expenditure) price index is announced, and as that is the Fed’s preferred inflation guage we can expect some volatility. Just what we need. Not.

The futures . .

As it is 36 hours to the next market open they don’t really mean much at this stage, but here they are anyway:

European summer

Readers who have been following this blog for a while will know that I love to spend my summers in Europe, to escape the Australian winter. Not that it is bad; the weather is usually quite pleasant but Idon’t like it getting dark by 6PM and not light until 7AM.

The one bad thing about travelling is having to work on a laptop; I hate not having my big screens and having to deal with hotel wifis, so if the quality of the blog goes down I apologise in advance.

Hoever, I will console myself with looking at the view

Heather Cullen Blog IN The Money Reversion to the Mean

Pretty stunning, no? Fingers crossed for a good week.

Heather

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