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How a Mean Reversion Strategy Can Take Advantage of Mispriced Stocks

A mean reversion strategy to the stock market can be applied in a variety of ways. Investors can take advantage of mean reversion whether through value investing or a momentum based trading strategy. Contributor Andy Shuler takes a look at mean reversion in this blog post, describes it and shows how it can be used with a technical analysis approach to the stock market.

Mean Reversion is not something that’s specifically tied to the stock market by any means. It applies to many things – one of which I specifically think of is a player shooting free throws in basketball. 

If a basketball player who historically shoots 75% from the free throw line has just made 10 in a row, odds are that eventually that player will start to miss more free throws, so his average reverts back to that normal mean of 75%. 

Same for the opposite – if the player misses 10 in a row, bet the house that they make the next one!  Not guaranteeing they will, but looking at historical averages, they should slowly revert back to that 75% mean.  This is a very basic example, but it’s the essence of mean reversion. 

Now, time for the fun, nerdy stuff 😊.

A Mean Reversion Strategy for the stock market simply is looking at the mean price of a stock over a certain period of time and then selling that stock when the price is significantly over that mean price, and then buying when it is significantly under that mean price. 

This makes a large assumption that prices will typically stay fairly consistent and not make major drastic changes, which can obviously have an impact if that is not the case. 

When I do this, I use the following steps:

  1. Determine the time-period that I want to use – typically, I will use a 90-day moving average
  2. Determine what the high and low points are, i.e. the points where you want to buy and sell the stock
  3. Be prepared to pull the trigger and buy when the stock is low and sell when the stock is high

In general, the Mean Reversion Strategy tends to work best with stocks that are very cyclical, such as energy or consumer staples, as they are affected my macroeconomic trends that tend to correct over time, so that’s something to consider as well when taking a reviewing this strategy.

Man, isn’t that easy?  It might seem that way, but it takes some effort and monitoring on your part.  This really is the definition of buy low and sell high. 

Mean Reversion Strategy: 90 Day Moving Average

For an example, let’s take a look at XOM. Below is a 5-year chart of closing stock prices and a 90-day moving average line. The moving average line is the line that is much smoother throughout the chart. Typically, I would like to target buying a stock when it is 8% below the 90-day moving average and sell when it is 8% above the 90-day moving average.

I also decided to go full nerd and tracked the last 5 years of XOM opening stock prices and implemented this Mean Reversion Strategy. 

I ran two cases which were very similar, with the only differences being 8% as a trigger for buy/sell and the other case was 5% being my trigger. 

I imagined that I started on 10/2/14 with 0 shares of XOM and the first day that the stock was < 8% of the 90-day moving average price, I bought 10 shares.  Then, I sold those same 10 shares the first day that the stock price was > 8% of the 90-day moving average, rinse and repeat. 

The other case, I did the same except with 5% being that trigger.  The results might surprise you…

As you can see, when looking at the 8% trigger point, the total return was -13.23% when I take my current value of stocks, as of 7/2/19, and add that to the increased value from selling my stocks throughout this period. 

-13.23% sounds pretty dang bad, and it is.  It’s disgusting to think about.  But let’s take a look at the 5% example now:

Still negative?  What the heck, Andy?  Yes, yes…I know…still a pretty measly return. 

But note the huge increase in the Mean Reversion Gain value of $184.90.  On average, you gained $18.49/share throughout this mean reversion process. 

So, why would you ever want to do this?  Well, let’s take a look at what would’ve happened if you just bought 10 shares on 10/2 and held onto them…

OUCH!  That’s the benefit of the Mean Reversion Strategy.  It’s really a blanket of safety.  It will alert you when the stock might be overvalued so you can sell, and then let you know when it’s undervalued and time to buy, therefore helping you identify the perfect time to buy low and sell high – the most common advice that you have likely ever heard with investing.

Overall, a Mean Reversion Strategy is a great tool to have in your investing toolbelt, per se, but it should not be the end all, be all of investing. 

This is a great tool that can really help show you what stocks can be undervalued and also identify some value traps that you might be falling into. 

There is always the chance that you might be buying before the stock bottoms and/or selling before that stock tops, but the general goal is that you’re constantly finding good values and buying/selling at opportune times – as you have likely heard, “don’t let perfect be the enemy of good.”