Is there a mean reversion anomaly?

There has been a fair amount of online discussion regarding mean reversion, typically focussed on the S&P500 or SPY ETF.

Michael Stokes shows that short term mean reversion is a recent phenomena and may actually now be inoperative:

http://marketsci.wordpress.com/2010/12/09/ramblings-on-the-state-of-short-term-mean-reversion/

David Varadi of the famous indicator DV2, presents 10 year backtests with impressive statistics.  The time period coincides with that shown by Stokes above.

http://cssanalytics.wordpress.com/2010/11/22/dv2-performance-in-review/

Larry Connors has a simple mean reversion system showing good performance stretching back to the 80s.  The rules are as follows:

  • Price must be above its 200-day moving average.
  • Buy on close when cumulative RSI(2) is below 5.
  • Exit when price closes above the 5-day moving average.

See http://systemtradersuccess.com/connors-rsi-update-for-2013/ for an equity curve and more discussion.

Sanz Prophet has a very nice implementation of an adaptive strategy which transitions from trend following to mean reversion around 2000-2003 and appears to be currently switching back.  This is a good illustration of the limited set of circumstances when short term mean reversion is found in the S&P500.

http://sanzprophet.blogspot.ca/2012/11/better-than-mean-reversion-adaptive.html

Engineering a mean reverting instrument

This is a popular strategy which looks for well correlated instruments and takes opposite positions when a pretermined drift has occured (e.g. 2 standard deviations), expecting “reversion to the mean”.  Also known as pairs trading and beyond the scope of this article.  Note that very closely aligned instruments are available such as IVV and SPY (which both track the S&P500), or an ETF versus a basket of its underlying stocks.  These are (or were?) fertile hunting grounds for hedge funds, until the inefficiencies are aritraged away.

Final thoughts

My view is that index mean reversion is not a pervasive enough anomaly to build a long term outperforming investment strategy.  Other disadvantages include: (often) a high number of trades (higher taxes and commissions) and limited academic literature on methods (e.g. published on ssrn.com).

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4 thoughts on “Is there a mean reversion anomaly?

  1. The one thing I see with most of these mean-reversion strategies is the bad streaks tend to all come from shorting when the market is overbought. Also only taking signals when the market is above the 200 DMA is key. I would like to see the strategies pre-2000 when it’s long-only and signals only taken above the 200 DMA.

  2. Yep I looked through it. Seems to agree that long only and above the 200 dma is a viable counter trend strategy. Nice post again

  3. Pingback: Daily Wrap for 5/21/2013 | The Whole Street

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