How To Invest

Mean reversion: How to profit between optimism and pessimism in the stock market

Market history gives us patterns and relationships that can be explained by market psychology and microeconomics. Knowing the patterns and what drives them helps us to uncover or validate (an increase in probability) of value investing opportunities. One such pattern is mean reversion.

Mean reversion in stock prices

Momentum is real. Stocks that go up tend to go up further, for no other reason than their share prices rising. Examples in the last few years include the stocks ensnared in the Blumont Saga in Singapore and Hanergy in Hong Kong. What investors fail to realize is that momentum does not last forever – especially if run-ups in share prices are not supported by solid fundamentals.

When sentiment is extremely bullish, it is hard to fight against the crowd. Luck may be confused with skill, and hubris tends to rear its ugly head. On the reverse end, when stock prices are depressed, investors tend to be overly pessimistic – seeing only gloom and doom.

Therefore, market prices tend to swing like a pendulum, from pessimism to optimism – and the more extreme each swing, the faster and quicker the rebound on the way back. Markets are ultimately made up of people, and it reflects the behavior of the crowd. Awareness of this is key, and as Sir John Templeton said, it is impossible to expect above average results by doing what everyone else is doing.

Mean reversion in business conditions

Ultimately, share prices must track the fundamentals of a business. But what drives the change in business conditions? The Capital Cycle is the easiest way to understand this. It is simply based on the idea that high returns attract excessive capital, and low returns lead to the exodus of capital.

Let me illustrate with the property cycle.

  1. When property prices are rising, developers see higher profits. They get more bullish and spend more bidding on acquiring land and expanding.
  2. Firms which do not normally engage in property development see this too and also start getting into the picture. At some stage, even foreign firms from China set up joint ventures to enter the market.
  3. Raising capital is easy at this point as the prospects of high returns leads to the inflow of capital.
  4. At some point in time, the equation reverses, as excess supply of housing outstrips the projected demand, or in other cases, and external shock (such as an economic crisis), leads to falling profits.
  5. Suddenly the picture looks less rosy, as buyers disappear and developers start to face financial distress. The sentiment gets worst as developers are faced with excess stock, and financial penalties to pay for unsold units.
  6. Eventually, developers decide that the prospects are bad, and source out better markets such as Australia and China. Eventually, pre-existing supply decreases as demand mops it up (from household formation and migration inward), and the cycle repeats.

If the above sounds familiar, it is because it describes the property cycle that plays out over years in Singapore and Hong Kong. The reason why cycles take so long is because of time lags. It takes time for land to be developed, for houses to be repossessed, and for household formation to wipe out existing supply.

This ebb and flow of the business cycle is what turns seemingly poor industries with poor outlooks into good businesses again – the lack of capital flowing into the industry and the removal of capital via the closure of existing businesses.

Understanding the Capital Cycle is crucial in helping investors understand why business conditions do not simply go to zero, and why they eventually improve, leading to stock market gains.

Read more: 4 strategies to overcome the effects of market psychology

Tay Jun Hao LLB

Tay Jun Hao is the fund manager of the Heritage Global Capital Fund at Swiss-Asia Financial Services Pte Ltd. Tay Jun Hao graduated with a Bachelor of Laws (Honours) degree from University College London.

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