The concept of mean reversion straddles a few disciplines. In psychology, regression to the mean describes the assessment of a particular variable that is less extreme than earlier observations. In scientific experiments, mean regression is a constant concern when determining accurate measurements. In finance, mean reversion explains why asset prices tend to move towards the average over time.
Mean reversion does not suggest that prices will always move towards the average but rather that as prices become extended, say a long upward rally, a correction towards the mean is expected. The theory behind mean reversion predicts that price corrections are a natural consequence of trading in financial markets.
Intuitively, share prices tend to move upwards as owners and managers try hard to improve the fortunes of companies. (It is rare that businesses are deliberately driven to extinction.) Naturally, in the process of trying to do better, there are winners and losers but, on average, there is a natural tendency towards improvement. In 1980 the Dow Jones Industrial Average (DJIA) share price was 900; in 1990 it had risen to 2,633; on to 10,600 in 2000; up to 11,500 in 2010 and onwards to its current price at 20,000.
There is no suggestion that the price moved upwards on every single day during these periods – it absolutely did not – and there were many long stages throughout the 1980 – 2016 timeframe where the DJIA fell significantly and took a long time to recover. But recover it did and that is the point to remember – over time share prices have a tendency to rise.
In this context the mean reversion is a controlling mechanism where extreme upward (or downward) movements are corrected by a return to average over time. Currently the DJIA 220-day moving average is 19,050. The 200-day calculation is used as an industry standard because it is more reflective of prices in recent market conditions.
Using the 200-day moving average as a mean reversion measure is one crude way of determining whether or not the DJIA is undervalued or overvalued. It should never be used in isolation when making an investment decision but it works as a simple rule of thumb.
The theory ofmean reversion is observed best in the foreign currency markets where the measurement evolves into the calculation of purchasing-power parity (PPP) between currencies – the notion that an identical basket of traded goods should cost the same in all countries. Where discrepancies arise between currency prices, the PPP points to the extent each currency has travelled from its mean reversion rate.
Along with other assets the US Dollar has risen strongly in recent months and is now 15% “overvalued” against the Euro. The pendulum is set to continue its swing; meaning that the US Dollar will grow stronger; moving further away from its mean-reversion rate. However, the principle of mean reversion will remain a drag until the US currency turns back towards its equilibrium price. Purchasing-power parity does not predict timing, however, simply direction.