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How I Learned To Love Mean Reversion & Stopped Worrying About The Bear Market at Trader’s Narrative





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The stock market’s resilience was in good form today as it inched ahead, managing to recover from the shallow pull back of 3 weeks ago. The Dow Jones even managed to put in a new high for the year while the S&P 500 index and the Nasdaq were not far behind. I’m not sure if this shallow pullback is what Lowry had in mind when they cautioned against jumping with both feed into their intermediate buy signal.

The tongue in cheek title of this post is inspired by the classic Kubric film, “Dr. Strangelove“. I thought of it when I looked at today’s chart of the day showing the subsequent returns for the worst yearly returns of the Dow Jones:

returns after worst declines Dow Jones chart of the day
Source: Chart of the Day

The 15 largest annual declines in the history of the Dow usually lead to a reversion to the mean. But not always. The 1930’s were as you’d expect, a wild card where bad simply got worse. Of course, back then you didn’t have the Fed opening the liquidity spigots like today. The only other outlier is 1978 which was slightly down during the brutal 1970’s bear market. Not surprisingly, when we step back and get some real perspective, cycles are obvious and we tend to go from bad to better. This is basically what I argued that Why Long Term Investors Should Consider Buying:

Can things get worse? Of course. But at this point, if you have a long term time horizon, a cast iron stomach for risk, the data suggests you should be taking small positions and slowly adding to them cautiously, even if the market continues to tank. That may sound crazy, but where we are right now in market history, only comes about very rarely.

Boy did things get worse. And if you were foolhardy (or smart?) enough to have an unemotional take on the market and a long term view, stepping into the abyss wouldn’t have been all that horrible. You would have been buying into a decline but in 4 short months, it would be all over.

In fact, we’re starting to see signs of real strength in the market. For example, the number of new 52 week highs in the US markets has recovered to pre-crisis levels:

52 week highs Bloomberg Oct 2009 chart of the day
Source: Bloomberg

Usually any measure reaching bear market tops sends shivers down one’s spine but keep in mind that this metric has not reached an extreme level. For example, consider that it was much, much higher towards the end of 2003 or early 2000 (not shown on the above chart). Both extremely unfortunate times to be long the equity markets. Right now however, we’re just seeing some resilience not speculative mania.

Yes, yes, I know the market is pricing in some insane numbers, including ginormous positive GDP growth and totally ignoring unemployment and a half-a-dozen other factors. What you have to remember is that the market does this all the time. In a bear market, it ignores bullish arguments repeatedly - until it doesn’t. And vice versa. So why argue?

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