PWL Capital August 14, 2015 Advanced Investing When is a good time to invest? Competing models of how markets behave provide an answer. A perennial question from investors is should I invest now or wait for a market correction? The answer is: invest now. We get to this conclusion by looking at the data invoking different models of how markets might work and testing to see how well they are supported by the data. Equity markets are noisy: prices fluctuate but we know the long term trend is positive, or else no rational person would invest. Sorting noise from underlying trends requires careful statistical analysis to be confident that the results have validity in different markets over different time periods. Two competing models are the random walk model and the mean reversion model. An example of a random walk model is a coin toss. The probability of the next toss being heads is 0.5, irrespective of what has gone before. Just because you observe 10 heads in a row does not change the likelihood of the next toss being heads, which remains fixed at 0.5. Many people have trouble with this and intuitively feel that a series of heads means that a tail is due. A competing model is mean reversion. In finance, mean reversion refers to the idea that future price movements depend on past price movements and, in particular, that below average returns are more likely to be followed by above average returns. Evidence for mean reversion would suggest that a period of above average monthly stock returns should make lower future returns more likely. If the data supported mean reversion in monthly market returns then it might make sense to try and time the market. Note that mean reversion suggests that under-performance follows over-performance and vice versa which means that returns are negatively correlated. The time frame of the reversion behaviour is also important. If measured over weeks or days then this is short term reversion. A related short term phenomenon is momentum (the trend is your friend) where short term returns are positively correlated. In this discussion we are interested in longer term mean reversion over months or years. The language we use matters and talk of market corrections are prevalent in the financial media, implicitly endorsing mean reversion According to the Merriam- Webster dictionary a correction is “a change that makes something right”. Using the phrase “market correction” implies consistency with the idea of reversion to the mean; that stocks have become overvalued and they need to adjust to more normal values. Many researchers have looked for evidence of mean reversion and broadly concluded that the evidence is inconclusive. Mean reversion, if it exists at all, is very weak. Mean-reversion, aside from being elusive in the data, doesn’t seem to make much economic sense either. Real growth rates of economies don’t revert to a mean but are driven by population and productivity growth. Neither of these factors are mean reverting over any timescales of interest to investors. Equity markets and economic growth tend to be linked so what would be driving mean reversion behaviour? As noted here, the market doesn’t believe in mean reversion either. This conclusion follows from looking at the cost of buying insurance (using options) against long term decline in equity markets. Mean reversion would suggest the cost of such insurance should decline with time but in fact it becomes very expensive. A recent study offered this conclusion: “For all intents and purposes, monthly changes in the …ERP [equity risk premium] are a random walk.” Any mean reverting behaviour is buried by daily volatility. At the time of writing, markets have fallen worldwide over the past two days, allegedly in response to the Chinese devaluing their currency. As a portfolio manager we always have cash to invest from clients. Am I pleased that I can buy for our clients today what was more expensive yesterday? For sure. Am I going to wait to see if I can buy those assets cheaper in a few months? Nope. Share: Facebook Twitter LinkedIn Email
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