Reversion to the mean...is the concept even relevant to investors today? Or have equities finally reached Irving Fisher's "permanently higher plateau" under the Federal Reserve's unconventional monetary policies? An investor might rightly ask that question because the Dow Jones has rallied and its gain in 2013 was its best year since 2003. One might characterize this as the Alfred E. Neuman market. "What, Me Worry?"
The Federal Reserve's unconventional asset purchases certainly acted as a prop to the US stock market by reducing investor uncertainty, and in turn, the need for diversification in alternative asset classes. As we enter 2014, the Federal Reserve is about to embark upon a policy shift and begin to reduce the amount of asset purchases it bought each month in 2013. This policy shift alone speaks to the need for investors to consider further diversification into alternative asset classes such as commodities and Managed Futures.
2014 in a nutshell
1. The Federal Reserve's policy shift is itself a form of mean reversion. This may be problematic for asset classes showing strong correlation to Fed policy.
2. Research by Debondt, Thayer, and others show that strong trends over the prior three to five years tend to reverse.
3. The outsized gains over the past 1-5 years in the US equity markets speak to a potential mean reversion independent of the Federal Reserve policy shifts.
4. Commodities annual returns have been negative for three consecutive years from 2011 through 2013. Since 1970, commodities have never been negative for three consecutive years.
5. Despite weakness in recent years, alternative asset classes offer investors attractive long term returns. Moreover, Institutional Allocation to these alternative assets are historically low. But Pimco and other large institutional investors have been re-entering alternative assets once again, indicating renewed interest in this neglected sector.
Our near future outlook:
Our forecast for 2014 is a bit tricky. On one hand we see a clear bull trend in US equities and almost no resistance from the "bears". On the other hand, US equity markets there are behavioral characteristics to the 2013-2014 US equity markets exhibiting strong correlation to the 1999-2000 and 1972-1973 stock market peaks. Understanding the market is the key to any strategy and successful portfolio manager. At this moment the US equity rally may not have legs past the first few weeks of the New Year before stumbling. Currently we are cautiously bullish US equities. But we are closely monitoring any changes in the market pattern and psychology because of the tendency for US equities to mean revert after a five year trend, as well as the behavioral traits reminiscent of prior stock market peaks.
Nell Sloane is a principal of Capital Trading Group LP (CTG). Nell began her career at the Chicago Futures Exchanges more than 25 years ago, working for a grain trader at the Chicago Board of Trade. She became a featured contributor to many financial publications and eventually launched her own commodity newsletter called The Opening Belle. She has been a featured speaker at numerous financial seminars and radio shows, and was recognized by financial publications such as Hume Super Investors Files, Opportunities in Options by David Caplan, McMaster OnLine by R.E. McMaster, and The Art of the Trade published by McGraw Hill.
If you have any questions about this article, please feel free to call Nell Sloane at 800.238.2610 or email her at NSloane@CTGtrading.com
DISCLAIMER: PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THEREFORE, NO CURRENT OR PROSPECTIVE CLIENT SHOULD ASSUME THAT FUTURE PERFORMANCE OF ANY SPECIFIC INVESTMENT AND/OR INVESTMENT STRATEGIES MADE REFERENCE TO ABOVE AND RECOMMENDED OR UNDERTAKEN BY CERVINO CAPITAL MANAGEMENT, WILL BE PROFITABLE OR EQUAL THE CORRESPONDING INDICATED PERFORMANCE LEVELS. DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ASSURANCE THAT ANY SPECIFIC INVESTMENT WILL EITHER BE SUITABLE OR PROFITABLE FOR A CLIENT OR PROSPECTIVE CLIENT'S INVESTMENT PORTFOLIO. HISTORICAL PERFORMANCE RESULTS FOR INVESTMENT INDICES AND/OR PORTFOLIO BENCHMARKS DO NOT REFLECT THE DEDUCTION OF TRANSACTION AND/OR CUSTODIAL CHARGES, THE DEDUCTION OF ADVISORY MANAGEMENT FEES, NOR THE IMPACT OF TAXES, THE INCURRENCE OF WHICH WOULD HAVE THE EFFECT OF DECREASING HISTORICAL PERFORMANCE RESULTS. HYPOTHETICAL RISK DISCLOSURE: HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN, IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.