Mean Reversion Is Your Friend

The popular rule “the trend is your friend” worked well in the past but during this year it has been challenged by erratic price action and swings. This could be a temporary phenomenon and momentum traders are not ready to accept that their rule is no longer valid. If not, then the new rule is “mean reversion is your friend.”

If indeed it is true that due to structural changes in the markets the popular saying “the trend is your friend” no longer works, then this has some important ramifications for traders and investors.

One of the most important ramifications is that in mean-reverting markets trading risk cannot be controlled with the use of stop-loss This is because applying stop-loss to mean-reverting strategies significantly impacts profitability.

In a nutshell and without going too much into technical details, mean-reverting markets reward high risk as opposed to momentum markets where risk can be controlled via the use of a stop-loss.

A few examples may help to illustrate the point: The first example is a backtest with SPY data for this year of a price series momentum strategy that goes long when price is above the 200-day moving average and exits the long when price falls below the average. Commission is $0.01 per share and starting capital is $100K.

spy_1_200_20161109

Annualized return is 4.92% with 6.01% maximum drawdown.

Next example is the popular 50-200 golden cross strategy: buy when the 50-day moving average crosses above the 200-day moving average, sell is it crosses below.

spy_50_200_20161109

In this case annualized return is negative and equal to -1.47% and maximum drawdown is 8.09%.

In comparison, our PSI5 proprietary mean-reversion strategy performance for this year is shown below:

spy_psi5_20161109

Annualized return is 17.77% with maximum drawdown at -4.96%.

There is a valid objection from momentum traders that this may be a temporary phenomenon. This is a respectable objection. But if the phenomenon lasts for a few years, then the stakes are high. No one knows the answer and a proper mix of both momentum and mean-reversion strategies may be one way to deal with this uncertainty.

More information of this major regime market change that essentially started in the late 1990s can be found in my paper “Limitations of Quantitative Claims About Trading Strategy Evaluation.”

In a nutshell, the root of the change was a major shift from high to low serial correlation in stock market returns, as shown in the S&P 500 chart below:

spx_autocorr_20161109

It may be seen that serial correlation was high and significant up and until the dot com bubble top and then turned negative. The horizontal bands mark the significance levels.  Serial correlation turned recently negative after a short period of a rebound.

Negative serial correlation may be a permanent phenomenon or it may last for several years. In this latter case, momentum traders will suffer and mean reversion traders will profit at their expense, i.e., momentum traders will pay mean reversion traders for assuming high risks.

However, no one can be sure about the future although prudent traders and investors should be prepared for different scenarios. Note that value investors and stock pickers will not be affected as there will always be securities that will uptrend regardless of market dynamics. But this is a different chapter.

If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY

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Charting and backtesting program: Amibroker

Disclaimer

Technical and quantitative analysis of Dow-30 stocks and 30 popular ETFs is included in our Weekly Premium Report. Market signals for longer-term traders are offered by our premium Market Signals service. Mean-reversion signals for short-term SPY traders are provided in our Mean Reversion report.

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