Regression to the Mean

"Everything regresses to the mean." Bill Bonner made that statement in his speech at the Agora Financial Wealth Symposium on Wednesday, and he’s been saying it for the last six years. This DR Classique first aired August 1, 1999…

This essay was inspired by vacation reading – Peter Bernstein’s Against the Gods. Anyone who is serious about investing should read it.

Charles Darwin’s cousin, Francis Galton, was fascinated by heredity. His illustrious family included far more great thinkers and achievers than mere chance would allow. Yet, when he studied the issue, he discovered that it was rare for greatness to persist in a family. A very accomplished parent would be likely to have children who were ordinary. This led him to the principle that we all know as "regression to the mean."

It is the principle we are applying to the stock market when we expect prices to return "to normal." But it has a couple of built in complexities. The most important of these is this: how can you know what’s normal? Much of life seems cyclical. The sun rises…it sets. Tides come in and then go out. Kondratief got sent to Siberia for finding long cycles in capitalism. But does human activity merely repeat itself over and over like the movie Groundhog Day?

Well…not exactly. In the 1960s…a new era began in US markets. The age-old relationship between stocks and bonds changed. Henceforth, people would be willing to accept stocks with dividends lower than the yield on bonds. This change was caused by another major change – the dollar was no longer backed by gold…and no longer a reliable store of value. Bonds were particularly susceptible to inflation…so people demanded higher yields.

The Market: Something Unexpected

This led a number of financial analysts – including many of my friends – to believe that things had changed in a much more fundamental way. They believed that the dollar would soon disappear…that gold would rise to almost infinite heights in dollar terms…and that bonds were merely "certificates of guaranteed confiscation."

But the market is a very tough competitor. When you think you have it figured out…it does something unexpected. It reacts to efforts to understand it…and frustrates attempts to profit at above market rates. That is why winning strategies do not hold up over time. The Dogs of the Dow concept was hot in the 80s. Then, people began using it. They bid up the prices on the dogs to the point where the strategy would no longer work. In the five years from March ’89…funds focused on international stocks went up 20%…the best performing sector. During the next 5 years they were the worst. Seeing that it was almost impossible to beat the market, investors loaded up on index funds and Dow stocks. And now that strategy, too, no longer seems to be working.

Still, regression to the mean is a fact. Markets do not go up forever. Everyone can’t become infinitely rich. Trees do not grow to the sky. There are limits, in other words. And the further a system goes away from its apparent mean…or centre…the more likely it becomes that it will reverse direction. At least…that is what I have always thought, intuitively.

If the direction of the market is completely random… and thus unpredictable…the pattern of up days and down days will follow the normal bell curve of random distribution. Two Baylor University professors plotted it out. Sure enough, they got a bell curve. In any given month, the odds that it will go up or down are little different than a coin toss (allowing for a slight upwards bias over time).

The Market: Something Odd About the Bell curve

But there is something funny about this bell curve. When you look at both ends, you see that they have humps on them. This is not an ordinary bell curve, in other words, which feathers out to nothing at the extremes. This bell curve shows a lot of action at the extremes. Peter Bernstein’s description:

"The chart of monthly changes does have a remarkable resemblance to a normal curve. But note the small number of large changes at the edges of the chart. A normal curve would not have those untidy bulges."

I think we are on to something big here…something that analysts have not noticed. It is probably true that stock market timing is usually a waste of time. Most days, most months, most years, the market direction is simply unpredictable, like the toss of a coin. But when the market is either very underpriced or very overpriced…at the extremes…nature asserts itself with a powerful tug back to the mean. Thus, when he sees the market at an extreme, the prudent investor should adjust his portfolio in the expectation that the market will regress to the mean, however inexact that may be.

Here’s how Bernstein puts it: "At the extremes, the market is not a random walk. At the extremes, the market is more likely to destroy fortunes than to create them. The stock market is a risky place."

Is the market at an extreme today? Or what?

Bill Bonner
The Daily Reckoning

August 12, 2005

Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).To purchase your copy of Financial Reckoning Day at a discount, see our bookstore:

"Whatever is going to happen is going to happen," says our Pittsburgh correspondent Byron King.

And what is going to happen, he points out, is that the world is going to pay a lot more for oil.

There are four ‘great tides’ in current history, Byron maintains. Conveniently, they all begin with the letter ‘d’: Debt, Depletion, Decline and Demographics.

You are already very familiar with debt, dear reader. We have bemoaned and bewailed the increase in debt since we began The Daily Reckoning six years ago. You may be less familiar with Depletion. It is what is happening to the world’s supply of ready resources – oil, water, and decent dirt.

"Don’t worry," Byron told his audience yesterday, "we’re not running out of oil. We’ll never run out of oil. The very first oil fields ever discovered, in Titusville, Pennsylania, still give some oil. They pump a barrel or two every day. But the trouble is, the world uses 80 million barrels every day. And they aren’t making more of the stuff. Oil production in America peaked out in the 1970s, just like Hubbert said it would. Now, oil geologists say worldwide production will probably peak out around 2010. After that, it’s all downhill."

Downhill for oil production means uphill for oil prices. It means that the easy-going world of cheap, abundant energy is finished.

"You know, when I buy an apple at the local supermarket in Pittsburgh, that apple may have been grown in Chile. There, they planted the tree with machines that ran on oil. They fertilized with oil-based fertilizers. They collected the apples with oil-burning machines…and drove them to market in trucks…and loaded them on ships…and took them all the way through the Panama Canal and up to Baltimore, where they were unloaded and put on trucks and delivered to my local store."

That whole economy is based on oil – affordable oil. But with oil production in decline…and oil consumption rising worldwide…oil will soon be much less affordable than it is now. And that will change the whole economy.

"We already know how it will affect the world. We saw what happened in the 1970s. Oil was trading for $11 a barrel. Then, the Shah of Iran was overthrown. And it was his buddies who were running oil production. In a matter of a few weeks, the engineers and managers you need to get oil out of the ground and to market had fled the country. Oil production in Iran collapsed from nearly 6 million barrels a day to less than 2 million barrels a day. That 4 million barrels a day difference sent oil prices up to $50 a barrel and caused the worst recession in America since the Great Depression. And that was back when the world was using a lot less oil than it is today."

If that isn’t enough, dear reader, remember – we still have two more ‘D’s…

More news, from our team at The Rude Awakening:

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Eric Fry, reporting from Wall Street…

Buffett unabashedly credits his infrequent investment activity for much of his success. In Berkshire Hathaway’s 1990 annual report Buffett wrote, ‘Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings.’"

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Bill Bonner, with more views:

*** Finally, a useful book is the number one bestseller on Amazon…

That’s right, the little wizard is still rummaging around on the ground looking for his glasses – in the number two spot, after Addison Wiggin’s The Demise of the Dollar (and why it’s great for your investments) stole his place on the list yesterday.

This five-star book (Harry Potter only has four stars) may not be your typical vacation read – but at least you’ll be the smartest one on the beach!

*** "You mean, there’s a real estate bubble in India too?"

We posed the question to our colleague, Sala Kannan, who follows Indian investments.

"Well, not like in the United States. Prices in India are rising, but they’re going up for good reasons, not for bad ones. Incomes have more than doubled in the last 10 years. It’s incredible. I got a call from a guy who used to be a cook for our family. He lived in a little hut. We paid him about 4,000 rupees a month, which was only about $90. But now, he’s opening restaurants all over Southeast Asia. A few years ago, Indians rarely went out to eat. Now there are restaurants opening up everywhere."

Property prices in America rise with debt levels. In India they rise with income.

"But foreigners are making a mistake when they invest in India," says Sala. "They’re putting their money into the IT sector, because that’s the sector that everyone knows. But in India, IT already has too much money. Prices are too high. What you need to do is to look where the money goes when it leaves the IT sector. It’s going into infrastructure, health care (especially pharmaceuticals) and property. There are still a lot of good investments you can make in those sectors."

*** A friend sends this little note:

"World famous ‘terrorists,’ who became Presidents/Prime Ministers of their countries, include Oliver Cromwell, Pinochet, Yomo Kenyata, Nelson Mandela and Menachim Begin amongst others. The last three having the honour of having tea and biscuits with the Queen."

*** Sixty years ago this week, the United States celebrated a sordid bit of history. The "Enola Gay," a B-29 bomber with a very special bomb named "Little Boy" on board, arrived over Hiroshima. More on the subject, next week…