Mean Reversion: The Iron Law of Financial Gravity
Mean Reversion: The Iron Law of Financial Gravity
EXECUTIVE SUMMARY
- The Law: In finance, trees do not grow to the sky. Asset classes that outperform their historical average for 3-5 years typically crash or stagnate until they return to the long-term trendline. This is Mean Reversion.
- The Mechanism: Capitalism attracts competition. If Tech stocks earn 50% margins, new competitors enter, driving margins down. If Oil stocks earn 0% margins, competitors go bankrupt, supply drops, and margins rise.
- The Strategy: Do not chase heat. Systematically rebalance from “Winners” (Overvalued) to “Losers” (Undervalued). This is the only way to “Buy Low, Sell High” without predicting the future.
Sir Isaac Newton figured out gravity for apples, and John Bogle figured it out for stocks. “RGM” (Reversion to the Geometric Mean) is the most powerful force in investing. It explains why the “Best Mutual Fund of the Decade” almost always underperforms in the next decade. According to Team BMT Analysis, betting against mean reversion is betting that “this time is different.” History says it never is. Source: Callan Periodic Table of Investment Returns
Scenario: Emerging Markets (EM) vs. US Stocks (S&P 500).
- Phase 1 (2000-2009):
US Stocks: -9% (Lost Decade).
Emerging Markets: +160% (The “BRICs” era).
Sentiment: “US is dead, buy China/Brazil.” - Phase 2 (2010-2023):
US Stocks: +400% (The Tech era).
Emerging Markets: +30% (Stagnation).
Sentiment: “China is uninvestable, buy US Tech.” - BMT Verdict: The winner of the last decade is usually the loser of the next. Chasing past performance is a wealth-destroying error.
Sector Performance Rotation
| Asset Class | 10-Year Forward Return (When Bought at Peak P/E) |
|---|---|
| Tech Stocks (Year 2000) | -3.0 |
| Value Stocks (Year 2000) | +6.5 |
*Chart Note: Buying the most popular asset at the peak of its cycle (High P/E) historically leads to negative real returns for a decade.
CRITICAL SCENARIO: The “CAPE Ratio” Signal
Predicting the next lost decade.
| Metric | Condition | Forecast |
|---|---|---|
| Shiller PE (CAPE) > 35 | Expensive (Current US Market) | Low Returns (0-4%) Expected |
| Shiller PE (CAPE) < 15 | Cheap (Emerging Markets / Small Caps) | High Returns (10%+) Expected |
Execution Protocol
Decide your mix (e.g., 60% US / 40% International) and write it down. This is your anchor. Without an anchor, you will drift into owning 100% of whatever is going up (the “FOMO” portfolio).
Once a year, sell what is up and buy what is down to restore your percentages.
Psychology: This feels terrible. You are selling your “best” performer to buy your “worst.” But mathematically, you are harvesting gains and buying low.
Don’t just own the S&P 500. Own Small Cap Value (#396). Value stocks often zig when Growth stocks zag. This ensures that when the market mean-reverts, you have a lifeboat.
Fail Condition: Capitulating after 3 years of underperformance. Mean reversion cycles can last 5-10 years. Patience is the only edge.
WEALTH STRATEGY DIRECTIVE
- Do This: Look at your portfolio. If US Tech is >50% of your net worth, you are betting against mean reversion. Diversify into boring assets (International, Value, Bonds) that haven’t moved much lately.
- Avoid This: “Linear Extrapolation.” Thinking that because NVIDIA went up 200% last year, it will do it again this year. The higher the price goes, the harder gravity pulls.
Frequently Asked Questions
Does mean reversion apply to Bitcoin?
Yes. Crypto has extreme boom/bust cycles (80% drops). However, because it is a new asset class, its “mean” is harder to define. It is more prone to “Momentum” than traditional mean reversion in the short term.
Can I short the market?
No. “The market can remain irrational longer than you can remain solvent.” (Keynes). Don’t short the bubble; just reduce your exposure to it and buy the cheap stuff.
What is the Shiller PE?
It is the Price divided by the average Earnings of the last 10 years (inflation-adjusted). It smoothes out business cycles to show if the market is truly expensive or just temporarily earnings-depressed.