Mean Reversion Trading

As the market grinds sideways heading into the end of April, it is a mixed bag as to which direction we are going.

Last week, StockCharts rolled out some new features. One of the big investing styles is reversion to the mean. The reversion can be planned from a number of different measurement tools, but a common one is a moving average. When something is well above or well below the moving average, an investor will look for a trade that reverts back to the moving average. I did a screen shot showing the new tool display, and I really like the functionality of it. Let’s investigate that a little.

The table below is one I produce each week in my newsletter. I have a few specific ETF’s in a list as well as the US Sectors. I changed the sort order to show how much each sector/ETF has changed over the last week in the % CHG – percentage change – column. That’s not new. But over on the right, there is a new column available. In this example I chose the 50 period moving average. This column displays how far above or below the moving average the current price is. It shows the current price level of the 50 DMA and the difference is colour coded.

I think this table does a wonderful job of explaining the current investing environment. Technology and Semiconductors are the farthest below the 50 DMA. Staples, real estate and utilities are very strong showing the current climate is defensive. It also shows the energy and materials as having extreme outperformance, especially E&P. If you were starting to look for reversion to the mean trades, it would be a good idea to look at what is very extended. let’s investigate utilities pulling back and semiconductors starting to outperform.

The outperformance of semiconductors compared to utilities (SMH:XLU top panel) ended in mid-January. Since then each semiconductor rally has been stronger, but each rollover longer. Until this trend changes again, this is a chart advising us of caution for mean reversion. You could also pick XLK:XLP on the lower panel, but it is telling us the same thing.

This new display by StockCharts can help us look for mean reversion trades, but you need a signal to start investing in one. So far that is not showing up for the technology area.

Good trading,
Greg Schnell, CMT, MFTA