Not a Mean Reverting Walk Down -Indian†Wall Street!

22 Jul 2022 , 12:18 PM

Mean reversion theory says that the price of a stock tends to revert back to its long term average price.  This theory was the basis of a 1989 paper by Richard Thaler. Thaler was the winner of Nobel Prize in Economics for his work in Behavioral Economics.  This 1989 paper was titled, A Mean Reverting Walk Down Wall Street.  In this paper, Thaler wrote that mean reversion works in the case of stocks over a 5-year period but not beyond that. Mean reversion starts working from 18 months and above. So if a stock underperformed in the past 18 months, then over the next 18 months it is going to outperform. This will happen because after falling down, the stock’s price will start rising to reach back to its long term average or mean price level. Similarly, if a stock outperformed in the past 18 months, then it is likely to underperform over the next 18 months. This will happen because its stock price will start falling down to its long term average price level.

In a research report dated July 21 2022, IIFL Capital Services tested the hypothesis given in this paper on Indian stocks. Analysis was done over a 14 year period between 2005 and 2019. Stocks in the universe of BSE 100 were included. The analysis resulted in the following key findings:

• Mean reversion is not strong enough or consistent enough to exploit in practical conditions
• Momentum sustains much more in bottom performers than in top performers in a 3-year look-back and look ahead analysis but shorting them can be tricky

The most important conclusion of IIFL securities is that mean reversion theory cannot be applied for stock selection to generate excess returns, in the case of Indian equities. A more fundamental driven stock selection approach, that is based on factors such as growth, profitability, cash flows, multiples etc. will be more successful than the mean reversion approach.

Comparison of worst BSE 100 performers in a 3-year period with Nifty in subsequent 3-year period — mean reversion does happen, but not outperformance

Current period	Top10 – 3yr CAGR (%)	Worst10 – 3yr Cagr (%)	Nifty Return (%) 3yr period
From	To	Top 10	Ex top 2	CAGR- Next 3 yrs	CAGR — Next 3yrs — Ex top 2	Worst10	Ex Worst2	CAGR- Next 3 yrs	CAGR — Next 3yrs — Ex Worst2
31-Dec-05	31-Dec-08	78.8	53.9	2.0	8.0	(28.3)	(26.0)	15.2	3.3	16.0
31-Dec-06	31-Dec-09	80.2	67.6	(16.8)	(19.7)	(23.8)	(22.0)	(8.9)	(10.8)	4.3
31-Dec-07	31-Dec-10	48.3	40.2	12.5	15.1	(37.7)	(35.1)	(21.6)	(16.8)	0.9
31-Dec-08	31-Dec-11	70.2	64.1	36.8	37.1	(24.2)	(21.9)	12.8	16.3	21.4
31-Dec-09	31-Dec-12	39.9	36.9	14.9	13.6	(27.3)	(24.8)	(7.6)	(9.5)	10.4
31-Dec-10	31-Dec-13	31.3	28.9	4.9	4.2	(28.4)	(26.3)	(7.0)	(4.7)	9.1
31-Dec-11	31-Dec-14	57.0	53.1	11.6	14.1	(8.4)	(4.1)	5.4	5.3	8.3
31-Dec-12	31-Dec-15	65.0	56.9	12.2	12.3	(21.0)	(17.7)	11.5	12.3	11.0
31-Dec-13	31-Dec-16	59.7	54.7	2.8	(5.7)	(19.7)	(15.7)	(10.9)	(9.1)	14.1
31-Dec-14	31-Dec-17	54.0	47.3	(6.6)	(8.3)	(10.8)	(9.4)	(15.4)	(16.6)	9.9
31-Dec-15	31-Dec-18	44.8	41.2	21.5	21.5	(18.8)	(15.0)	10.3	15.4	16.9
31-Dec-16	31-Dec-19	44.8	40.1	22.8	23.3	(21.2)	(16.9)	(0.6)	(2.4)	12.0
Average	56.2	48.8	9.9	9.6	(22.5)	(19.6)	(1.4)	(1.4)	11.2

Source: Bloomberg; IIFL Research

Read the full report here https://content.indiainfoline.com/Strategy/IIFL-Strategy-20220721.pdf