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


Unknown said...

Good post but I did have one question. Do you really believe that an event is more likely to happen because the insurance is expensive? I would think the event insured against is no more or less likely to occur but just that when it is expensive you would avoid it purely because its overpriced.

Also, even if mean reversion strategies will still work in the "new normal". Do you have any concerns that this may be or has become an overcrowded trade?

Unknown said...

Very interesting article. I found your point on hedging tail risk and cheap vs. expensive insurance thought provoking. However how can you tell if the insurance is expensive? Does this mean relative to the historical cost of the insurance?

mdblog said...

Interesting article, but one remark on the price of earth quake insurance in Tokyo: It makes sense for the price to go up after a quake, since it is an event, which is serially correlated. One quake happening raises the probability of subsequent quakes and so prices (for short term insurance) should go up.

Whether this explains all of the increase or whether there is also a psychological components, I don't know.

Unknown said...

III. Tail hedging becomes more important

Particularly when PIMCO has a brand new tail hedging strategy to flog(which will undoubtedly boil down to paying for the backside of the horse that just bolted).

WhiteShadow said...

JUST a matter of time ...mean reversion will not die so so many ppl say fundamentals are dead cos of HFT. To them and all others no believers of values, and basic market principles....

Unknown said...

I think the increase in market correlations (and asset class for that matter) should actually be benefical for mean reversion. The positions identified as statistical outliers should close easier and more consistently. I've explored this -and other themes here

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