Reversion to the mean

Mean reversion 

‘Regression to the mean’ is the most powerful law in financial physics: 'periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.’ 

Following on from the post of Dogs of the World, today let’s take a look today how you can use mean reversion in your investing in the stockmarket.

But, first up, a technical definition. Mean reversion, according to MathWorld, is:

‘The statistical phenomenon stating that the greater the deviation of a random variate from its mean, the greater the probability that the next measured variate will deviate less far. In other words, an extreme event is likely to be followed by a less extreme event’.

Its technical name is anti-persistence. And to be honest that’s a better label.

Why?

Because mean reversion doesn’t mean that the variable will return to the average value and then stop - because as we know in markets, you can shoot a long way past the mean and appear to be wrong for quite a while.

There is no inherent time limit for mean reversion to take place. 

Think of it this way: if you’re in a room full of people the average male height will be about 5ft 10'.

Now if a 7-foot-plus giant walks in, you don't really expect the next dude after that to be 7 foot or taller.

You recognise him as an ‘outlier' and predict the next guy will be closer to the average. 

And in most, cases this is usually what occurs (unless you happen to be at a Harlem Globetrotters convention). 

The tricky thing about mean reversion is that it is counter-intuitive. 

Most folks get caught in a trend that they reason will go on forever. But feeling both positive and negative, can be deadly. 

We humans prefer stories rather than statistics. Stories give meaning, they connect what appear to be separate events. 

They just make sense to us. 

But you should give preference or at least an equal weighting to statistics. It is worth noting that algorithms are more reliable than humans because they don't have feelings. 

Mean reversion in markets  

Take the energy sector - I mentioned in my Dogs of the World post how if you had bought it at the end of 2016, you would be very happy.

Now imagine telling your friends that oil and energy is the place to be.

Yep, a place where the past two years of losses had equalled approximately 50 per cent, disaster headlines everywhere and predictions of alternative energy takeovers in the air.

The same thing happens with countries falling in and out of favour. 

Recognise that mean reversion is a statistical phenomenon.

Think about it. The average annual return (the mean) over around 90 years for the US stock market is about 10 per cent, or thereabouts. 

However, the market seldom returns 10 per cent. In most years returns vary between minus 16 and plus 16 per cent.

The market posts a majority of the annual returns either above or below the mean.  

Some luck...

Golfers know mean reversion well.

They set up at the tee and hit their drive.

They miss the fairway but hit a tree and the ball rolls back onto the fairway. Smile :-)

They play on and get a par.

Now, imagine the scenario if the same ball hits the tree and bounces into the water, or a parallel fairway? No smile :-(

Par becomes double bogey (note how many investors tell you about their skills, but not how lucky they are - more than a few of us do that in golf too!). 

Thirdly, mean reversion and correlation are two sides of the same coin.

Francis Galton - Sir Francis to his mates - discovered long ago that correlation and regression were not two different concepts but simply different perspectives on the same concept.

The general rule is pretty straightforward - whenever the correlation between two scores is imperfect (meaning a correlation figure of less than 1) then there is mean reversion. 

This is very important for two reasons.

Firstly, in markets, you need to understand that price is important. Because if it wasn't then price would be irrelevant and so you could buy any asset or stock at any price and it could just continue tracking upwards forever. 

It also means that the best time to buy is when the price of an asset is below the mean; and the further away the better. 

Buying when everyone is despondent about an individual stock, sector, country or style is tough. But it is rewarding. 

Into practice

So, how do you use it in your investment approach?

Consider this - if mean reversion is a real ‘thing’ and it exists in markets - which it has proven to do - then you want to buy on the ‘low’ side not the ‘high’ side.

If the average annual return is approximately 10 per cent then you want to be buying when the returns are lower or even negative.

Why? Because mean reversion works then you will generate outsized returns as the market reverts.  

By the way, US markets have been expensive of late. 'Fore!'.

Construction cycle set to roll over

Houses hold up approvals

Building approvals held up well in April 2018, still tracking at 19,000 per month in trend terms.

You can click on the images to make them bigger, if you want to.

It's still very much hammer time for Melbourne apartments, but Sydney unit approvals continued their decline to sit at the lowest level since August 2015. 

I've been watching the budding Hobart supply response with mild interest, as well as noting some of the subdivisions and, shall we say, rather ambitious sticker prices for townhomes.

And like many things in Tassie, the supply response been rather slow.

That said, it is now happening, with annual approvals at an 82-month high in rising to the highest level since June 2011. 

Overall, the headline numbers were pretty good, thanks to more houses and semis now being approved, notably following population flows into Melbourne and Greater Brisbane, while Perth finally recorded a bit of an uptick, having fallen so sharply since December 2014. 

Annual house approvals in Perth are 45 per cent below their 2014 peak, but the sentiment and the clouds appear to be lifting a little. 

Summarily, pretty solid then.

But - and this is a fairly big but - many apartment projects seem to be struggling with pre-sales and therefore with financing, and in turn the residential construction cycle appears set to fade.

There is already a record number of apartments approved and not yet commenced, especially in Sydney, and approvals to non-resident approvals have been curbed dramatically. 

Queensland infrastructure lift-off

The total value of building approved remained strong in the month at more than $10 billion, but arguably a fair chunk of that residential building work approved will never see the light of day, and non-residential approvals are now sliding too. 

The one shining light is Queensland, where all the talk of commercial projects is now finally translating into action stations. 

However, the sugar-hit for Melbourne and Sydney eventually looks set to wear off.

Overall, then, these figures appear consistent with the construction cycle rolling over this year.

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More detailed thoughts and implications can be found in our monthly reports for fund managers.

Return of the mining town investor?

What's old is new again

Maybe imminent, looking at the vacancy rate figures in Muswellbrook!

Please note this is not a recommendation.

Source: SQM Research

Meanwhile the Geelong housing market is doing kind of what we expected it  would:

Source: SQM Research newsletter

Podcast: How my investment strategy has changed

Different times, different strategies

Low wages growth and tighter credit.

There have been plenty of changes in the real estate landscape over the past couple of years.

How do property investors need to adjust their strategies, particularly with regards to the end-game?

There are also some key considerations relating to interest-only loans.

Tune in here where I discuss my personal thoughts at Property Update.

Foreign investment in new apartments annihilated

Foreign investment in housing smackdown

The Foreign Investment Review Board (FIRB) released its Annual Report for the 2017 financial year, and as expected it showed that investment in new apartments from mainland Chinese investors has been annihilated by a combination of fee charges and tighter capital controls.

There's much more to the Annual Report than just the residential real estate investment aspect, of course, but this is a blog not an Encyclopaedia Britannica so let's crack straight into it.

Although the impact on total foreign investment was played down in the report, the reality is that the number of residential approvals have been smoked, down by 67 per cent from the prior year. 

Similarly the value of residential approvals crashed 65 per cent lower from $72.4 billion to $25.2 billion. 

The bulk of new approvals through this unprecedented cycle have been for new dwelling exemption certificates, mainly for Chinese investors.

Looking at these numbers it's not hard to understand how Sydney now has more apartments approved but not yet commenced than at any time in its history, as detailed here previously.

The offshore buyers have dried up, demand from domestic investors has been stymied, and the demand from owner-occupiers is insufficient to get new development project finance across the line. 

Statistically it appears to be a certainty that Sydney will experience the greatest number of failed apartment projects as these trends flow through. 

I expect to see plenty of apartment projects stalling, and increasing signs of discounting on new Sydney apartments.

Perhaps this was an inevitable end-game for this cycle, where development has been too much skewed towards apartments for investors, and too little towards the types of medium-density dwellings that people want to reside in.

The wrap

As noted, there is much more to foreign investment than just new apartment purchases, with total investment of $168 billion only 4 per cent below the level seen in the prior year. 

And indeed, investment in manufacturing, agriculture, ports, other commercial real estate, and resources has catapulted China to become by far and away the greatest investor in Australia at $38.9 billion in FY2017, miles ahead of the United States in second place at $26.5 billion.

Nevertheless, these figures will have some significant impacts on the new apartment sector, construction trends, and the broader economy - and especially so in Sydney.

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For more details, please subscribe for our monthly report for fund managers. 

Diamond Dogs (with apologies to David Bowie)

Market dogs

I'm mostly known as a 'real estate guy', but I do invest in the share markets - mainly via index funds - and a few people have asked me to write a bit more about the 'Dogs of the World' approach to investing.

The concept of Dogs of the World isn't new, and the idea of buying what's unloved is almost as old as the hills. The 'dogs of the Dow' strategy was popularised in 1991, for example, which focused on buying the 10 stocks with the highest dividend yields.

And Dogs of the World certainly isn't cool right now. But that's actually the entire point. Dogs of the World is about doing precisely what's not trendy, which is one of the reasons why it's so darned difficult to do.

But buying investments when they are cheap and the markets are having conniptions does have one wondrous and proven benefit: it works!

When first introduced to this idea I'll admit I was sceptical, as I am of most such things, but my colleague Steve Moriarty has been using this strategy for more than 15 years now and has been seeing returns of 15 to 20 per cent per annum.

I back-tested the numbers - it works, and smarter people than I have concluded the same thing. Let's take a quick introductory look, and I'll revisit the subject in future posts. 

Buying a dollar for 50 cents

One way to outperform the stock markets over the decades has been to find and then invest in wonderful businesses. Another key element has been having the wisdom and patience to wait until those enterprises are cheap before buying in meaningful volumes. 

Alas, most people don't have the ability to analyse companies very well, and certainly not as adroitly as the great value investors. In fact, to be brutally honest, most people are hopeless at analysing company financials in any meaningful way.

But that doesn't mean that you can't aim to buy investments when they are cheap, and Moriarty has explained to me how individuals can apply similar principles in a less risky manner. 

Market dogs in action

The basic principle of the market dogs strategy is to invest in the most unloved companies, or sectors, or asset classes, or countries.

For example, can you remember how bad everything was in the energy sector through 2014 and 2015 as the oil price collapsed? Refer to the green boxes in the graphic below. Summarily, it was pretty morose.

Indeed, it was the end of the world according to some of the usual suspects - some of whom somehow still manage to sneak their way onto my Twitter feed, despite being muted half a dozen years ago! - posting up their analysis after the event to explain why the oil price was a bubble (worse than useless, but thanks anyway!).

Energy was the worst performing sector of the market for two years consecutively as investors rushed for the exits (click to enlarge the images).

-/

Source: Novel Investor

The market dogs principle holds that you would then buy the unloved sector of the preceding years, and sure enough in 2016 the energy sector delivered the strongest sectoral performance in the S&P 500 market at +27.4 per cent.

Of course, our simple brains are not wired to work in this way at all. Instead, it feels much safer to do what everyone else is doing.

Despite my inherent snark, I might be doing the social media Armageddonists a disservice. They may, after all, serve one very useful purpose: when they've become alerted to a market crunch and start telling you that the 'smart money' is now short or selling, this might well prove to be a signal that the worst has now passed - a contra-indicator in real time, if you will. Exhibit A from one of the said usual suspects:

In a similar vein, when all those truckloads of books came out in 2009 explaining after the event how the subprime crisis and subsequent great crash of 2008 happened, that was an optimum time to be buying stocks, certain classes of real estate...you name it. Returns from the US stock market since Q1 2009 have been spectacular, and so too have the returns from some residential real estate, commercial real estate, and an array of other assets that were on sale.

Of course, in many respects it was also the hardest time to be buying, with the end of the world apparently nigh. But the Dogs of the World strategy cares not about the prevailing sentiment, it merely compels you to buy when markets are cheap and on sale.

Trend not always your friend

So, what's become hip today? At the moment everyone seems to be talking about technology or IT stocks (refer back to the orange squares in the sector performance graphic above) which have delivered positive returns every calendar year since crashing spectacularly in 2008, as they are periodically wont to do. 

Buy and hold investors generally don't like this kind of volatility; yet this same volatility can be the best friend of the market dogs investor. When people and sentiment are pessimistic about a volatile industry then the price falls can be very sharp, but mean reversion then eventually delivers positive returns. 

All around the world

You can apply similar principles to investing in the stock markets of other countries, or at least exchange traded funds (ETFs) which fulfil that job for you. 

For example, take a look at Ireland's stock market returns (turquoise boxes in the graphic below) which suffered a sharp 20 per cent correction in 2007, then followed by a catastrophic crash in 2008, dropping by more than 70 per cent in that calendar year alone.

You'd have needed a little patience in this instance, but buying markets when they are so remarkably cheap can deliver outstanding returns, simply through reversion to the mean (from 2011 until 2018 in this case). 

Source: Novel Investor

And to take a look momentarily at the local Ireland stock market index (ISEQ) graphically. Wowsers.

Source: ISEQ

Of course, you probably aren't going to move to Ireland and buy shares in the local index in a local currency. But there are two beautiful things about investing today.

Firstly, you can easily buy ETFs (through, for example, iShares) that do the job for you. And secondly, there is so much data available, that you can readily back-test any investment strategy.

Dogs of the World can be as simple or as complex as you choose to make it. Poring endlessly over inflation rates, currency swings, and relative dividend yields can become very confusing, and you can receive contradictory signals.

But the fundamental principle of buying low and selling high can be elegantly simple - using this strategy you may need to invest only once per year - although in my opinion it would only form a part of a sensible portfolio, rather than being the core of it. 

Emerging markets crack (Turkish delight)

In investing there is a risk hierachy, and as a general rule investing in a sector of the market or the index of a country is less risky than investing in an individual company.

Take a look back at the international stock market returns graphic and you will see the biggest challenge facing the Dogs of the World strategy right now. And that is that most assets are expensive today in this era of low interest rates, with 2017 delivering positive returns across most almost all countries, and most sectors. 

However, rates are now tightening in the US, and the US remains a major influence on global stock market valuations. And there are already some signs of cracks in some emerging markets.

An investment in a Turkey iShares ETF (TUR) has been a shocker since 2008 - even with all of the dividends invested a notional $100,000 invested would find you with 20 per cent less today than you started out with. Not so much Turkish delight there,

But that's kind of the point. With the ETF product now showing a P/E ratio of under 8.5, the entire country is practically on sale. 

Actions, not words

Of course, I'm not saying that you should be getting ready to buy Turkish equities in 2019. After all, I don't know anything about your personal tax position, money management skills, or your tolerance for risk. 

For one thing, the outlook can always get worse before it gets better, and by its very nature the Dogs of the World strategy is mentally very challenging to put into practice. In short, you have to develop the ability to hold your nose and buy anyway, and markets can always become even cheaper so asset allocation is vital here too. 

When markets are at their most unloved the media headlines will be hollering in their most acute tones, as they presumably are about Turkey right now.

More than that, imagine for a moment that on 28 May in 2012 you'd told your friends and family you'd decided to buy $100,000 of shares in Irish equities because the market had crashed and it had become very cheap. 

They'd quite possibly have thought that you'd lost your mind. Yet roll forward to May 28 this year and including the dividends reinvested your $100,000 is worth more than $¼ million, ready to be rolled into the next big opportunity. 

At the moment, the trendy thing seems to be talking about shares in companies like Netflix (NASDAQ: NFLX) - or 'Debtflix' if you prefer - a tech stock that has gone parabolic, and has just risen to yet another all-time high. 

With a P/E ratio of somewhere way north of 220 in the past week and a market cap of well over US$150 billion Netflix is now valued at more than Disney! Even just based on the movies, merchandise, and general exposure in my household alone, I can see that this is some seriously irrational pricing.

Last year, some people were prepared to pay close to $400 for a single share in Tesla (NASDAQ: TSLA). It's not a fashionable thing to point out by any means, but even today the market is still valuing Tesla - a loss-making company that's burning through cash like there's no tomorrow - at about US$50 billion, which is another idiosyncratic state of affairs.

I can't predict the future, but mean reversion is a powerful leveller, and it's not hard to imagine that ending painfully when the tide goes out. 

Dogs of the World is about doing the opposite of that. Which means buying investments when they are cheap and letting mean reversion do the heavy lifting for you, instead of trying to pick up pennies in front of Tesla- or Netflix-shaped steamrollers.

It's a proven and profitable strategy, and I'll add some further details and ideas in future posts. But I warn you in advance, your friends will think you're barking mad!

Auctions volumes smoked

Stamped out

Median prices have been holding up reasonably well, although Melbourne house prices finally look to have cracked a little. 

But auction sales recorded are waaay down.

Source: Domain

On the same weekend last year $1.7 billion sold under the hammer.

This year the equivalent figure was a paltry $653 million.

That's a heck of a lot of stamp duty not being collected in the tighter lending environment. 

Just one of the reasons I don't believe there will be much appetite for it to last too long.

Lower bank profits and corporation tax receipts will be another. 

Who'd be a regulator?

Weekend reads (growth mindset)

Weekend reads

The must read articles of the week, summarised for you here at Property Update.

Growth mindset

It will soon be your last chance to sign up for Wealth Retreat 2018.

Quite apart from the Gold Coast, the golf, and the goal setting (and, for me, reviewing last year's goals), I'm looking forward to invaluable business coaching from Mark Creedon, and learning from the mind of US Rich Habits guru Tom Corley. 

Then there's the technical stuff, on mortgage lending, changes to tax legislation, structures, and the other fundamentals you need to know to gain the 'unfair advantage' of the wealthy.

I'll also be sharing my latest work in some in-depth presentations. 

More than anything else I can't wait to network with positive, like-minded people, as great things somehow always just seem to happen when you do that. 

It's interesting to look back, years ago I used to think that investing a lump sum in a 5-day event sounded like a waste of money.

These days I get the dollar value back (and then some) almost instantaneously from picking up a single useful business, motivational, or investment idea, or making one new genuinely useful connection. 

It's genuinely fascinating to me how you develop over time. 

You can sign up for Wealth Retreat here .

It's a great event, but it's not for everyone - it's really only for motivated or positive-minded people that want to achieve bigger and better things. 

But if you read my blog, you're most likely that personality type. At least I hope you are :-)

I look forward to seeing you there!