Stock Trends Reversing to the Mean

Nothing makes a financial journalist salivate more than the sweet sound of statistics to make their stock market warning article sound more legitimate.

Of course, numerous statistics are meaningless, others are easily cherry-picked based on data, and still others are far less useful or predictive than other statistics that might not say the same thing.

Today’s fun example comes courtesy of MarketWatch and the gloomy warning that U.S. Stocks could be in for a world of hurt if this trend reverses to the mean.

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World of hurt?” – Whew! Pulling hard on our masculine headline click bait phrase dictionary this morning are we?

stock market world of hurt
I’m gonna find Phoenix, and I’m gonna put him in a hurt locker. — Demolition Man

What Is Reversing to the Mean?

Reverting to the mean is the statistical probability that for any observation away from the mean, the more likely the next observation will be closer to the mean.

An easy way to think of this is if the mean speed of cars passing by on a road is 55 mph, and one goes by at 95 mph, statistically the next card that goes by will do so at a speed closer to the mean than 95 mph, that is 94 mph or less.

Obviously, this is not a hard and fast rule (statistics never are, the whole point is PROBABILITY, not prediction.) In fact, if you think about it, there are a whole set of variables that make the probably that there will be a reversion to the mean more or less likely. For example, if the speed limit in that section is 55 mph, reversion is much more likely, doubly so if there is visible speed trap, and so on.

Lots of Market Statistics Could Revert to the Mean

As the U.S. economic expansion, and stock market rise continues into the what must eventually be the twilight of this particular bull market, more and more measurements are drifting far from their mean. A reversion to the mean of any one of them would necessarily come with an adjustment to stock market prices back down as well.

So, I guess it’s just an easy way to crank out a few hundred words and hit publish to notice that over the past 30 years that large U.S. stocks and large European stock prices have moved mostly the same. However, that has not been true for the last 10 years where U.S. stocks have outperformed European stocks by a large measure.

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Which brings us to the world of hurt headline. IF this particular, pull it out of a hat, trend were to revert to the mean, U.S. stocks might have a spectacular fall to come back into line with the usual condition of having approximately the same return as European stocks.

Of course, if you want to go with the full statistical picture, the same condition could revert to the mean via a spectacular run up in the price of European stocks. Who knows maybe after they sort that whole Brexit thing, the European stocks will take off and bring the numbers back in line.

Also, we’ll ignore that if we are comparing historical 30-year data to current 10-year data, statistically, we have 20-years before this comparison is valid anyway.

Ignore This Headline

Either way, grab your cup of coffee and don’t worry about this one.

If you want to ponder, I’d stick with the Fed’s recent rate cut, which probably doesn’t help or hurt. A recession is coming, of course. That’s just the way the cyclical market works. No expansion lasts forever. But a recession doesn’t have to be a crash, and it doesn’t have to last long. The data isn’t there yet, but that won’t stop folks from guessing to get a little headline space.

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