Mean-Reversion on Equity Index Level

Buy the Dip? Not before the 1970s.

December 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Mean-Reversion on index level became profitable post the 1970s, before that Momentum dominated
  • The structural shift from Momentum to Mean-Reversion is consistent across markets
  • Likely explained by the evolution of financial markets

INTRODUCTION

Investors and traders basically only have two options when it comes to investing: speculate on Momentum or Mean-Reversion. Naturally these options can be played across different time frames, e.g. high frequency trading versus value investing, different asset classes and across or within securities. It is difficult to say which force is stronger, there is sufficient empirical research on both strategies, e.g. Value as a form of long-term Mean-Reversion and trend-following as form of Momentum. In this short research note we will analyse how these two forces played out in the short-term on equity index level across markets (read Death, Taxes and Mean-Reversion).

METHODOLOGY

We focus on short-term Mean-Reversion and Momentum (being the inverse) on equity index level in the US, Europe and Japan. We show the results for Mean-Reversion portfolios, which are created by measuring last weeks return as an entry signal, which is delayed by one day to make trading realistic. If the index return was positive, a short position is entered, while if the index return was negative, a long position is taken. Portfolios are created each day and held for one week, therefore the portfolio can fluctuate between being 100% net short and 100% net long. Transaction costs are excluded as we are primarily interested observing the two forces and not creating an implementable trading strategy.

MEAN-REVERSION & MOMENTUM IN THE S&P 500

The chart below shows the short-term Mean-Reversion strategy in the S&P 500 from 1900 to 2017. The inverse of the chart would represent short-term Momentum. We can observe that from 1900 to 1972 the Mean-Reversion strategy consistently lost money, i.e. Momentum dominated on the stock market. From 1972 onward Mean-Reversion became a consistently profitable strategy while Momentum therefore became unprofitable.