Reversion to the Mean

Mean reversion is the theory suggesting that prices and returns eventually move back to the mean or average.  This mean or average can be the historical average, or another relevant average, such as growth in the economy.

Applying this theory to the major stock market indices, such as the S&P 500 and the Dow Jones Industrial Averages (DJIA), shows that the long term trend line is remarkably consistent, with average annual growth rates in the high single digits.  Looking at the trend lines over the long term, even dramatic short term market moves, such as the more than 20% single-day drop in October 1987, become almost impossible to discern.

Currently the major stock market averages may appear to some observers as being above their long term trend lines, due to the significant gains since the November 2016 election.  They are not.  Current stock market averages are still below the long term trend.  Markets, and other forms of measurable data, can diverge from long term trends for long periods.  Investors should be very careful, and note that efforts to market time, by attempting to measure the degree of short term divergence, may be riskier than expected.

Investors would be well advised to be aware of divergence from trend and consider adopting appropriate rebalancing of portfolios to maintain long term objectives.

Walter J. Kirchberger, CFA®