Reports of the death of mean reversion are premature

James Montier has written great piece on Mean Reversion & the "new
normal" - sharp, very sharp talk from him. Enjoy.

http://behaviouralinvesting.blogspot.com/2010/08/reports-of-death-of-mean-reversion-are.html

http://www.puc-rio.br/marco.ind/rev-jump.html

Friday, 20 August 2010
Reports of the death of mean reversion are premature
This was originally written for the FT, but they seem to have gone the
same way as so much media and are dumbed down these days - they said
it was too technical (after sitting on it for more than a week). So
I'll post it here in:

In a recent article [1] Richard Clarida and Mohamed El-Erian of PIMCO
argued that the 'New Normal' offered at least five implications for
portfolio management.

I. Investing based on mean reversion will be less compelling

II. Risk on/risk off fluctuations in sentiment will continue

III. Tail hedging becomes more important

IV. Historical benchmarks and correlations will be challenged

V. Less credit will be available to sustain leverage and high valuations

Implications IV and V seem pretty reasonable to me. However, reports
of the death of mean reversion are premature. I fear that the authors
are confusing the distribution of economic outcomes with the
distribution of asset market returns. The distribution of economic
outcomes may well turn out to be flatter, with fatter tails than we
have previously experienced.

However, asset markets have long suffered such a distribution; it has
proved no impediment to mean reversion based strategies. In fact, the
fat tails of the asset market have provided the best opportunities for
mean reversion strategies. For instance, in equity markets the fat
tails associated with unpleasant outcomes (poor returns) have
generally occurred as high (sometimes ludicrously high) valuations
have returned towards their 'normal' level, and the fat tails which we
all love (good returns) have occurred as low valuations have moved
back towards more 'normal' levels.

As long as markets continue to follow the second implication (as they
have done since time immemorial) and flip flop between irrational
exuberance and the depths of despair, then mean reversion (at least in
valuations) is likely to remain the best strategy for long-term
investors. (This also highlights the apparently contradictory nature
of the first two implications that the authors point out). We don't
require long periods of time at equilibrium for mean reversion
strategies to work, rather (and considerably less onerously) we simply
require markets to pass through the equilibrium periodically.

As always, investors need to be mindful of the context of their
investment decisions. It is always possible that we are standing on
the brink of a shift in the level to which asset valuations mean
revert. But that has always been the case. Only careful thought and
research can work to try to mitigate the dangers posed by this threat.
After all, if investing were both simple and easy, everyone would be
doing it.

The third implication that tail risk hedging will become more
important is and always has been true (much like the second
implication). The prudent investor should always pay attention to tail
risk – the new normal doesn't alter that.

Ever eager to please, the 'engineers of innovation' (or should that be
the 'architects of destruction'?) are happily creating products to
serve the new bull market in tail risk. Deutsche Bank is launching a
long equity volatility index, while Citi has come up with a tradeable
crisis index (mixing equity and bond vols, swap spreads and structured
credit spreads). Strangely enough, Bloomberg reports that PIMCO is
planning a fund that will protect investors in the event of a decline
greater than 15%. Even the CBOE is planning a new index based on the
skew in the S&P 500.

However, any consideration of the purchase of insurance should not be
divorced from a discussion of the price of the insurance. Cheap
insurance is wonderful, and clearly benefits portfolios in terms of
robustness. However, the key word is that the insurance must be cheap
(or at very worst fair value). Buying expensive insurance is a waste
of time. I used to live in Tokyo and was constantly amazed that the
day after an earth tremor the cost of earthquake insurance would soar,
as would the demand!

You should really only want insurance when it is cheap, as this is the
time when no one else wants it, and (perversely) the events are most
likely. Buying expensive insurance is just like buying any other
overpriced asset ... a path to the permanent impairment of capital.
Rather than wasting money on expensive insurance, holding a larger
cash balance makes sense. It preserves your dry powder for times when
you want to deploy capital, and limits the downside.

So buy insurance when it's cheap. When it isn't and you are worried
about the downside, hold cash. As Buffett said, holding cash is
painful, but not as painful as doing something stupid!

In summary, the new normal may pose some issues for investors who have
never bothered to study history (which is, of course, littered with
many, many 'new normals'). However, for those with perspective,
prudence, patience and process, many of the same 'eternal' rules are
likely to govern the game as they always have, come rain or shine. In
essence, many of the implications are less the new normal, and more
the old always!

[1] Uncertainty changing investment landscape, Market Insight, 2 August 2010

Posted by James at 00:54