## **Market Extensions & Reversions To The Mean**

**Market Extensions & Reversions To The Mean**

Now that we have defined what overbought means – I can explain what I mean by overextended. As I discussed in “Revisiting Bob Farrell’s 10 Investing Rules”:

“Like a rubber band that has been stretched too far – it must be relaxed in order to be stretched again. This is exactly the same for stock prices that are anchored to their moving averages.

Trends that get overextended in one direction, or another, always return to their long-term average.Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

The chart below shows the S&P 500 with a 52-week simple moving average. The bottom chart shows the percentage deviation of the current price of the market from the 52-week moving average. During bullish trending markets, there are regular reversions to the mean that create buying opportunities. **However, what is often not stated is that in order to take advantage of such buying opportunities profits should have been taken out of portfolios as deviations from the mean reached historical extremes.** Conversely, in bearish trending markets, such reversions from extreme deviations should be used to sell stocks, raise cash and reduce portfolio risk rather than “panic sell”at market bottoms.

## **Market Extensions & Reversions To The Mean**

**Market Extensions & Reversions To The Mean**

Now that we have defined what overbought means – I can explain what I mean by overextended. As I discussed in “Revisiting Bob Farrell’s 10 Investing Rules”:

“Like a rubber band that has been stretched too far – it must be relaxed in order to be stretched again. This is exactly the same for stock prices that are anchored to their moving averages.

Trends that get overextended in one direction, or another, always return to their long-term average.Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

The chart below shows the S&P 500 with a 52-week simple moving average. The bottom chart shows the percentage deviation of the current price of the market from the 52-week moving average. During bullish trending markets, there are regular reversions to the mean that create buying opportunities. **However, what is often not stated is that in order to take advantage of such buying opportunities profits should have been taken out of portfolios as deviations from the mean reached historical extremes.** Conversely, in bearish trending markets, such reversions from extreme deviations should be used to sell stocks, raise cash and reduce portfolio risk rather than “panic sell”at market bottoms.

The dashed red lines denote when the market changed trends from positive to negative. **Understanding, and identifying, when markets change trend is the very essence of portfolio **“risk”** management.**

The idea of “stretching the rubber band” can be measured in several ways, but I will limit our discussion this week to **Standard Deviation** and measuring deviation with “Bollinger Bands.”

“Standard Deviation” is defined as:

“A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of the variance.”

**In plain English this means, and as shown in the chart below, is that the further away from the average that an event occurs the more unlikely it becomes.** As shown below, out of 1000 occurrences, only three will fall outside of the area of 3 standard deviations. 95.4% of the time events will occur within two standard deviations.

For the stock market, and as shown in both charts above, the standard deviation is measured is with Bollinger Bands. John Bollinger, a famous technical trader, applied the theory of standard deviation to the financial markets.

**Because standard deviation is a measure of volatility, Bollinger created a set of bands that would adjust themselves to the current market conditions.** When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average).

The math is pretty straight-forward as shown in the table below. (The only difference between 2, 3 or 4 standard deviations from the mean is the multiplication factor at the end of the formula)

This can be calculated in Excel by using the STDEVPA formula as follows:

On this year, the dollar tanked (worst since 2003), stocks and bonds (the long-end) soared higher, commodities rebounded dramatically, cryptocurrencies exploded, and gold had its best year since 2010 as VIX saw its lowest average in history... and all that driven by the biggest increase in central bank balance sheets since 2011... anyone else feel like this... (our estimate is we are at around the 30 second mark currently)

RECORDS>

### __2017...__

**Now that was a year for stocks...**

- The Dow is up 25% over 2017, putting it on track for its second straight annual increase, as well as its
**best year since 2013.** - The S&P is up 20% year-to-date. Like the Dow, it is set for its second straight annual increase and its
**best year since 2013.** - The Nasdaq is up 29% in 2017, its
**best year since 2013.**2017 is set to be the Nasdaq’s sixth straight annual gain. According to the WSJ Market Data Group,**this is the longest streak for the Nasdaq since a six-year streak lasting from 1975 to 1980.** - The Russell has gained 13.6% in 2017. The index is set for its
**second straight annual gain.**

**Additionally, The Nasdaq also has posted a record number of all-time high closes this year.**

**Vols across every asset class collapsed to multi-year (if not record) lows...**

The collapse in the yield curve (2s30s) is the **biggest flattening since 2007...**

**This is the flattest yield curve since Oct 2007...**

**The Dollar was a bloodbath this year** - the biggest loss for the greenback since 2003...

### __In December...__

- The Dow is up 2% in December.
**This will mark its ninth straight monthly rise, its longest such streak since 1959.** - The S&P is up 1% thus far this month. This will also be the S&P’s ninth positive month in a row, representing its best streak since 1983.
**On a total-return basis, however, the S&P is set for its 14th straight monthly gain, which will lengthen a record... and is the first "perfect year" of 12 straight months in one calendar year gains.** - The Nasdaq is up 0.5% in December, which will represent its sixth straight monthly increase.
**The tech-heavy index has risen in 13 of the past 14 months.** -
**The Russell is down 0.5% in December.**breaking its longest winning streak since Feb

Ugly close to the month...

Finally, if there is one chart that sums up 2017, it is this...

* * *

**Happy New Year to all... and remember, on Tuesday... It's...**