Two friends catching up in a coffee shop got into an interesting conversation as ‘The Long Run’ by the Eagles started playing.

Ram: ‘The Long Run’ reminds me of something I heard recently and didn’t understand. A market analyst said that eventually stock prices return to the long run mean or average. What does she mean?

Veena: She must have been referring to the concept of mean reversion. It is a financial theory that postulates that after extreme moves in either direction, asset/stock prices tend to revert to their long-term average or mean. So, amongst other metrics, this is one additional tool to analyse whether stocks are undervalued or overvalued.

Ram: By prices, you are referring to what?

Veena: Oh yeah, let me clarify this. I was referring to the valuation of the asset. For example, in the case of stocks you can take their P/E or P/B ratio. You could also apply it at an index level or even at a broader level like the market cap to GDP ratio. Some hedge funds and sophisticated traders also apply this concept to the aggregate profit margins of companies and make top-down investment decisions based on which direction the margins are likely to trend based on mean reversion.

Ram: So, in case of a stock, if because of a big jump in stock price the PE ratio has increased significantly over the long-term average, then does that mean the stock is overvalued?

Veena: Mean reversion is one amongst multiple ways to assess if a stock is overvalued but it cannot be the sole metric. It is important to assess whether there are any fundamental factors that have changed for a stock. This may indicate reversion is less likely or can be delayed beyond normal timelines.

Ram: Can you give some examples?

Veena: Yes. There are instances of stocks getting re-rated. For example, when the stock of a company like Reliance Industries which was earlier a petrochemicals company successfully expanded into growth businesses like retail and telecom, its valuations got re-rated and hence reversion to long-term mean became less likely going forward. Similarly, as Reliance gained dominance in the telecom market, the business model of many other telecom companies was permanently impacted and their stocks never recovered despite trading substantially below their long-term mean. Many of them got delisted, eventually.

Ram: What about investing strategies based on mean reversion?

Veena: There were many mean reversion trading strategies that worked well in the first decade of this millennium as they had in the previous century as well – like buying a group of stocks at certain percentage levels below their mean P/E valuation and then selling them at certain percentage levels above the mean P/E valuation or long-short quantitative trading strategies used by hedge funds and traders based on this concept. However, for many such traders, the same strategies have not worked out well since around 2010-11.

Ram: Why is that?

Veena: Some experts are of the view that aggressive expansion in balance sheets of global central banks that flooded markets with liquidity, and the ultra-low interest rates changed the market dynamics. So, mean reversion strategies based on bullish view on value stocks and bearish view on growth/premium stocks did not yield desired results as high valued growth stocks continued to outperform under-priced value stocks through most part of last decade. When global interest rates were at near zero levels, investors were willing to pay more for growth stocks.

Ram: So, with current expectations of monetary tightening by the US Fed in 2022, is mean reversion likely after the significant move in PE valuations that we have witnessed since January 2020?

Veena: Yes, that is possible. PE multiple expansions must be supported either by higher long-term earnings growth or lower interest rates for long periods or other factors like better corporate governance. Once sentiment and liquidity have played their part, fundamentals will finally matter the most. That is the time when mean reversion will play out.

Ram: So, 2022 is going be a strong test case for the mean reversion theory?

Veena: Oh yes!

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