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 [email protected]
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