Does Mean Reversion Always Hold True?

Tue, Mar 6, 2018 - 2:38pm

Summary

  • Only select sectors have historically reverted to the mean when at extreme levels
  • There are times when mean reversion is inconsistent
  • The frequency of outperformance differs across sectors
  • There is a unique relationship between relative performance and time horizon

Introduction

The S&P 500 took to the sky in 2017 gaining almost 22%, extending this current bull market further and approaching what could become the second longest in history according to Chris Puplava’s most recent quarterly newsletter Records Were Made to Be Broken.

Though returns in 2017 made the record books, history has shown us that good things don’t last forever. In fact, there is the old adage that excess in one direction leads to an opposite excess in the other. For a long time, contrarians, value investors, and technicians have developed trading strategies based on mean reversion—purchasing (or shorting) securities that have outperformed (or underperformed) the broader market. But how reliable is this strategy?

Financial Sense Wealth Management conducted a study looking at the returns of different sectors that underperformed the S&P 500 by at least 2 standard deviations or greater. Finding real value in “cheap” underperforming sectors is an often used investment strategy, but does not apply equally well to each of the 9 major sectors of the market. The following is a breakdown of our study and results, which we apply towards the active management of our client portfolios.

Methods

Going back to 1989, we looked at the 12-month relative performance of 9 of each of the S&P sectors versus the S&P 500 including:

  1. Industrials
  2. Financials
  3. Energy
  4. Information Technology
  5. Consumer Discretionary
  6. Materials
  7. Consumer Staples
  8. Health Care
  9. Utilities

We then used the relative performance of each sector to find the z-score (definition) or the number of deviations of each sector’s relative performance from its historical average. After we grouped occurrences where there was a -2 standard deviation underperformance or greater of the sector relative to the S&P500, we found the corresponding 1-month, 3-month, 6-month and 12-month forward relative performance to determine whether mean reversion occurred and resulted in outperformance.

Results

1. Only select sectors have historically reverted to the mean when at statistical extremes

One of our main objectives throughout this study was to determine what sectors historically have performed the best relative to the S&P on a risk-adjusted basis when they have significantly underperformed the broader market. Shown in figure 1 (click any image to enlarge) are the best performing sectors ranked top to bottom when relative performance vs. the S&P 500 was at a -2 standard deviation or more event. Based on the data, sectors like Industrials, Consumer Discretionary, and Health Care have historically offered the greatest risk-adjusted return, on a relative basis, in the forward months when that sector has underperformed the S&P 500 by at least 2 standard deviations.


Figure 1 - Sources: Financial Sense® Wealth Management, Bloomberg.
Past performance is no guarantee of future results.

Shown in figure 2 below are the best performing sectors on a risk-adjusted basis when even further statistical extremes have occurred (-3 standard deviation or more). During occurrences of poor relative performance beyond 3 standard deviations, sectors like Information Technology, Consumer Discretionary, and Utilities have historically yielded the greatest risk-adjusted return in the months ahead.


Figure 2 - Sources: Financial Sense® Wealth Management, Bloomberg.
Past performance is no guarantee of future results.

What does this mean for investors? Well, for those that accept the concept of mean reversion, these sectors historically have offered the best return with the lowest volatility when already at extreme levels of underperformance.

Solely on an absolute relative-return basis under extreme conditions (-3 standard deviations or more), we found that Information technology, Utilities, and Industrials outperformed the S&P by the greatest percentage in almost all the proceeding months within a year’s time.

2. There are times when mean reversion is inconsistent

Another objective of ours was to determine if there have been occurrences when mean reversion does not take shape. From our data, we found that there were a few sectors that, on average, showed little to no attempt in returning to their mean no matter how extreme their oversold condition in the market—for example, Financials, Consumer Staples, and Energy. However, it is important to note a few points:

  • The data obtained for our financial sector is largely skewed to the left in terms of concentrated distribution. This is possibly due to the 2008 financial crisis—a period when many financial institutions experienced a slow recovery from extremely oversold levels.
  • Looking at Consumer Staples, the sector’s forward returns seem to have little to do with their over or underperformance to the market. This could likely be explained given the fact that this sector generally offers steady dividends, strong financials, and are less volatile relative to the rest of the market.
  • As shown in Figure 3 below, Energy showed a weak correlation between oversold conditions and positive forward relative performance. In fact, the more the sector underperformed the S&P 500, the forward relative performance worsened. For this reason, our data suggest that mean reversion is rather inconsistent when analyzing the energy sector.


Figure 3 - Sources: Financial Sense® Wealth Management, Bloomberg.
Past performance is no guarantee of future results.

3. The frequency of outperformance differs across sectors

The frequency of positive relative performance over time is also a significant factor that we wanted to look at. Based on the data, the same sectors that typically provided the best risk-adjusted returns once oversold, did so with the highest probability of overperformance relative to the S&P as shown in figure 4 below.


Figure 4 - Sources: Financial Sense® Wealth Management, Bloomberg.
Past performance is no guarantee of future results.

These three sectors were shown to outperform the S&P 500 often when they underperformed the S&P by at least a -2 standard deviation event.

Based on these results, another observation is that each sector has its own characteristics when it comes to their mean reversion life cycle. For example, the cyclical nature of the Industrial sector shows that once mean reversion begins to take place, the longer you hold it from an oversold level, the higher the chance you have of outperforming the S&P 500.

Consumer Discretionary had a dip in its 6-month likelihood (or frequency of returns) of overperformance relative to the S&P 500, which, we believe, is most likely due to seasonal factors that align with many retailers and their annual business cycles.

Health Care showed a near opposite mean reversion cycle than the Industrials sector. Based on our data, healthcare had a relatively short-lived bounce in relative performance, between one to six months, after being a statistical underperformer of the market. Our data for the healthcare sector also suggests that when considering the six- to the twelve-month time frame, mean reversion has already exhausted itself as investors have moved on to more attractive sectors.

4. There is a unique relationship between relative performance and time horizon

The last and final point to be made is regarding the relationship between forward relative performance and time horizon. Based on a regression analysis, we found that only a select few sectors had a positive correlation between higher returns and a longer time horizon:

  • Industrials – 96% correlation
  • Consumer Discretionary – 94% correlation

Of the sectors that underperformed the S&P 500 by at least a -2 standard deviation, Industrials and Consumer Discretionary had the strongest positive correlations between increasing relative performance and forward months.

Looking at sectors that have underperformed at further extremes (-3 standard deviations or more), we discovered an even stronger correlation between higher relative performance and forward-looking months. Technology and Industrials were among the sectors with the highest correlation at these oversold levels. On the opposite side of the spectrum, Energy was a sector that historically has underperformed the S&P and continued that downward trend in forward months when negative relative performance is at an extreme.

Conclusion

Based on the study, our findings suggest that mean reversion is a likely contributor to forward returns in most sectors. However, the extent to which mean reversion plays a role and how strong the reversion is depends on the sector itself. While mean reversion is a powerful trend, it is important to note that not all sectors are created equal, nor do they behave in the same manner. Some sectors exhibit longer periods of outperformance, while others historically tend to have shorter lifecycles from their current statistical underperformance.


Financial Sense Advisors, DBA Financial Sense Wealth Management, is a Registered Investment Advisory firm providing services in the areas of Wealth Management, Financial Planning, Retirement Services, Insurance and many others. If you would like to speak with one of our licensed Wealth Managers, please give us a call at (858) 487-3939, or Contact Us.

Disclosures: All data has been provided by Bloomberg. This information is for educational purposes only and is not intended to be investment advice. The information provides here does not consider reader’s suitability or risk tolerance. Be advised that you invest at your own risk. For your particular financial management needs and situation, please consult your financial advisor.

About the Authors

Ryan Preiss, CRPC®