President and CEO

An Assistant Vice President, Betsy Lim serves as one of the Bank's Loan Officers. Her responsibilities include servicing loans, credit underwriting for prospective and existing loans, and preparing annual loan reviews. Ms. Lim joined the Bank in 2005 with international commercial banking and finance experience gained in the Philippines and Hong Kong. She received a BSc in Business Economics (magna cum laude) from the University of the Philippines and an MBA from the University of Toronto. Betsy enjoys eating Chinese food and reading historical non-fiction. On the weekends, you'll find Betsy playing the tourist, and exploring New York's museums and flea markets.

Mean Reversion

By: Justin Frankel and Jeremy Berman - Wavecrest Asset Management

In the short term, markets tend to move randomly, but in the longer term, they have normally distributed returns.  There are many experts who believe they can divine the direction of markets in different ways.  Technical analysts believe they can read charts and lines to determine market direction, while fundamental analysts build models to analyze the financial condition of a company.  Momentum investors believe that the market is going to keep going in the direction that it is already moving, while market timers think they can accurately choose the inflection points of market moves.  The concept of mean reversion does not rely on the subjective measures or inputs that influence these other forms of analysis.  Mean reversion is the idea that market returns follow a somewhat normal distribution, and will generally move back to their average.  While overlooked during the volatility of the past three years, it remains an important concept for investors who want to manage risk.  The concept suggests that above average returns will more likely be followed by below average returns, and vice versa. 

We can imagine a game in which we flip a coin 100 times and keep a running count. Starting at a base of 0, we would add 1 for every time the coin lands on heads and subtract 1 for each time it lands on tails.  Assuming a fair coin, the probability of each toss is 50/50, but the path over the 100 flips will be random, and the likelihood of the count ending at 0 is very small.  However, the 0 acts almost as a magnet, sucking high or low numbers back to it.  The more times we flip the coin, the stronger the pull of the magnet.  This example is instructive of our initial point that in the short term markets move randomly, but in longer increments, markets are mean reverting.

It is important to note that it is not prices but rather returns that are mean reverting.  IBM, for example, closed the month of June near $170.  There is no stock price (say $150) that will act as the magnet in the example above.  Because of factors like stock buybacks, splits, dividends, and inflation, the actual price of a stock will not exhibit any mean reversion, but the percentage returns of IBM should, over time, revert to an average return.

There are many reasons why market returns exhibit mean reversion tendencies and move back to equilibrium:

1) Inflation - Central banks often pump liquidity into their economies to help generate growth.  Once growth has taken hold, they will start to remove that liquidity so as not to spur price inflation.  The removal of this accommodative policy may begin to slow growth, starting the process over again.

2) Price / Earnings ratio - Equities rise for different reasons, but ratio expansion (or contraction) is a common one.  If investors believe that a company will continue to grow its earnings, they will often pay a higher multiple for a stock.  When multiples rise to a certain level, some investors will start to believe that a stock is overvalued and start to sell it, thus lowering the price and the ratio.  Conversely, when ratios fall to a certain level, some investors may believe a stock is undervalued and start to buy it, thus raising the price and ratio.

3) Competition - When companies make above average profits in a particular region or a particular product, their competitors notice.  Unless one company has some form of strategic competitive advantage (it's a government owned entity or it owns all of a particular natural resource for example), other companies will flock to that region or product to capture some of that excess profit, thus lessening the spoils for the rest of the competitors.

4) Supply and demand - In commodity markets, simple supply and demand issues drive mean reversion.  When oil prices rise, gas prices typically also rise, and consumers start to drive less.  This reduces the demand and price for oil.  This can also be seen in oversubscribed initial public offerings, like the recent IPO of LinkedIn, in which the lack of shares available to the public at the initial offering created a buying frenzy that caused the stock to more than double in price on its first day of trading.

5) Globalization / Capital flows - Foreign direct investment and global capital flows are causes of mean reversion as well.  Manufacturing moved to China as they could produce quality goods for a cheap price.  As the Yuan continues to strengthen and the Chinese people demand a higher standard of living, more regional competition is occurring, and manufacturing demand is reverting to other nations like Vietnam, where the quality to price ratio is better.

A strategy that is grounded in the concept of mean reversion is likely to exhibit less volatility over longer periods of time. Momentum strategies perform well until the momentum shifts, and technically and fundamentally based strategies are ultimately only as good as the data that goes in to their models. As we move through the changing economic landscape, it is important to understand why markets move the way they do, and have a plan in place to capture market gyrations. Understanding mean reversion can help you create a portfolio that can weather all investment climates to both increase return, and reduce risk.

Amber Quiñones

David Ruiz