And the seasons they go round and round, And the painted ponies go up and down

We’re captive on the carousel of time

We can’t return we can only look behind

From where we came

And go round and round and round

In the circle game
— The Circle Game, Joni Mitchell

Mean reversion and momentum are arguably the two most powerful forces in markets. While these two influences can sometimes work in tandem, they often stand in fierce opposition.

Mean reversion: Valuation’s revenge

Mean reversion describes the tendency of returns to gravitate toward their long-term average. At times when broad asset classes have experienced higher than average returns, they have subsequently delivered subpar performance, while producing streaks of better than average performance after periods of subpar returns.

Countries whose markets have outperformed their peers by large amounts have subsequently underperformed, while previously unloved regions have gone on to be investor favourites. Similarly, “winning” stocks and sectors have morphed into stragglers, while those that were neglected have become market heroes.

Whenever a given stock, sector or market has delivered higher than average returns for an extended period, this outperformance is usually accompanied by lofty valuations that are fundamentally unjustifiable. This eventually leads to underperformance and a related return of valuations to more rational levels.

By the same token, at times when a given asset or group of assets has experienced below-average returns for a prolonged period, their multiples tend to become unreasonably depressed. The resultant “bargains” ultimately attract investor interest, which in turn leads to outperformance and the establishment of more rational valuations.

Momentum: The road to Valhalla and dystopia

The other principal force that drives markets is mean reversion’s volatile counterpart, momentum. Momentum investing capitalizes on the tendency for trends to persist by buying into rising assets and selling into falling ones.

Unlike mean reversion, which is based on fundamental valuation principles, momentum is best explained by behavioural biases and emotions. Spurred by fear of missing out (FOMO) and greed, investors tend to buy assets whose price has been rising, leading to further gains. In similar fashion, fear and despondency can cause people to sell assets whose price has been falling, thereby reinforcing negative trends and causing additional losses.

Mean reversion, momentum and the market cycle

The market cycle can be divided into four phases.

First phase: The March to Valhalla. At the beginning of this phase, overly optimistic assumptions about the economy or profit growth cause prices to begin straying above their fair values. This deviation can also stem from overexcitement about some theme du jour, such as

technology stocks

during the dot-com bubble, real estate during the years preceding the great financial crisis, or, dare I say, today’s

artificial intelligence

-related companies.

By the end of the period, optimism morphs into full-blown euphoria, causing many assets to be priced to perfection. This leaves them offering little, if any, upside while harbouring significant downside risks, as was the case from late 1999 to early 2000.

Second phase: The beginning of the end. This period takes the reins from its predecessor when broad sentiment starts to turn and fear begins to take centre stage, thereby causing prices to start falling.

Negative momentum begins to take hold, causing prices to continue declining. This dynamic continues until assets are once again realistically priced, as was the case between the peak of the dot-com bubble and the bear market bottom of late 2002.

Third phase: The end of the world is nigh and I will never invest in anything again. At this point, fear and skepticism begin to metastasize into full-blown panic, causing a final death spiral in prices, as occurred towards the end of the tech wreck in mid-to-late 2002.

By the end of the period, sentiment becomes completely washed out, with many assets lying at materially depressed valuations that offer significant upside for relatively low risk.

Fourth phase: Maybe things aren’t so bad; I like bargains. By this point, many investors have run for the exits, as was the case at the bottom of the early 2000s bear market.

Tempted by bargain basement valuations, a minority of rational and courageous contrarians begin stepping in to scoop up bargains, sparking a nascent recovery.

This rise in prices attracts additional buyers, leading to further gains until assets are once again neither materially undervalued nor overvalued.

The circle continues. Repeat phases 1-4.

Momentum is a fair-weather friend. Value is forever

Over the short term, momentum and sentiment are the primary determinants of asset prices. Rationality and traditional valuation principles are widely forgotten, which can lead to irrationally high or senselessly low prices.

Notwithstanding that such extremes have historically reverted, investors have time and again failed to take advantage of this fact, joining the overwhelming chorus of “this time it’s different.”

Valuations and mean reversion have historically been the primary determinant of returns over the medium to long term.

Where is the mean reversion boogeyman lurking today?

Given the historical tendency of yesterday’s leaders to become tomorrow’s laggards and for yesterday’s dogs to emerge as tomorrow’s darlings, it is worth noting that there are currently several divergences across markets, ranging from significant to extreme in terms of their magnitudes.

Within the

United States equity market

,

value stocks

are materially undervalued versus their growth counterparts, standing in the very depressed bottom part of the historical range of their valuations relative to growth stocks.

From a country or region perspective, Canadian stocks currently lie near all-time lows in terms of their valuations relative to U.S. equities.

Eurozone and Japanese companies currently exhibit the largest valuation discounts to their U.S. counterparts, lying at relative multiples to U.S. companies that are almost unprecedentedly low.

Trying to perfectly time the relative performance of asset classes is an exercise in futility. Still, those who are seeking to add value over the medium to long term should give some serious consideration to tilting their U.S. portfolios in favour of value stocks and adjusting their geographical exposures in favour of non-U.S. equities.

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Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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