Mean reversion and the great headline turnaround of 2012

Was it the news itself or the fact that European leaders found some common ground that drove markets higher? Whatever the case I think what we have seen in a number of markets is something of a bump on both sides of the trading range and now there is a decent chance that we are headed back to the mean so that everyone can have a chance to reassess what’s going on. Even though there is an awful lot for Europe (and indeed the rest of the world) to work through in the years to come the fact that the recent Euro summit found some common ground offers a glimmer of hope that needed action can be taken – not so sure on a timetable for that as yet. Importantly though, if you think that headlines could be a proxy for a market barometer then we are far from getting out of stormy conditions anytime soon. Or perhaps this is just another day in ‘the new normal’.

Last week I put together an article (which you can see here Are the markets all sold out?) that was using oil as an example of the particularly sideways nature of markets at the moment. The way in which you can measure this is by looking at standard deviation bands around a long-term moving average – I used 200 periods in this case. The time that you will likely find a good tendency for mean reversion is when prices are drifting sideways in a range. Take a look at the article from the other day and then take a look at the EURUSD 4 hour chart below:

You can see that the most recent peak and trough respected the +/- 1.25 SD bands around the 200 period moving average on the 4 hour chart. The reason why this is interesting is because you can see that the bands that I mentioned are now running largely sideways which would suggest that a move by the market back toward around 1.2560 seems reasonable.

Given what we have seen in the last few days compared to the last few years in Europe would make this move far from surprising – an initial bout of exuberance being followed by a reassessment of what it all means and whether it’s worth being excited about – so you may feel that all the standard deviation assessment is unnecessary. Perhaps, but this type of mean reversion assessment is a mistake that is easily made in trending markets and is one of the big problems that traders come up against when using Bollinger Bands.

There is a lot to think about what the news out of Europe means for the future but if you believe in the mean-reversion story then the immediate reality probably lies somewhere between the bulls and the bears. One of the best pieces that I read on the most recent European summit came from Wolfgang Münchau in a piece written in the Financial Times titled The real victor in Brussels was Merkel. Not to be a killjoy but the following shows what we have to deal with in Europe and what we have the capacity for so far –

“The real constraint for ESM bond purchases had less to do with the rules than with the overall size limit of the ESM. It has a lending capacity of €500bn – and that has not changed. No matter how you twist and turn it, the ESM is simply not big enough. It will inject equity into Spanish banks. It will need to refinance the programme for Greece, Ireland, and Portugal. It will soon have to cope with Cyprus and, who knows, maybe Slovenia as well. A full-scale programme for Spain still looks likely. I cannot see how you can fit Spain under the umbrella, plus Italian bond purchases.”

Speaking of headlines, concern for the future was big news when the Chinese PMI figures were released on the weekend which came in at 50.2. Whilst not in a ‘pessimistic’ phase as yet this data has really added fuel to the fire of those making the bear case for China. The biggest one that I saw (which was actually printed before the PMI data) was one written by Jonathan R. Laing titled Falling Star and it appeared on the cover of the latest issue of Barrons. Regardless of your opinion of the Chinese economy it’s worth a look but the thing that I took away was not only the substance of the article (I hope) but the fact that the chorus of economic bears is roaring even more strongly that we have seen in recent times. Perhaps with the elevated nervousness everyone wants to work extra hard to predict the next big negative driver.

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2 Responses to Mean reversion and the great headline turnaround of 2012

  1. stefanogianti says:

    Reblogged this on Bearish & Bullish.

  2. Pingback: Aquila Resources breaks descending triangle | CMC Markets Blog

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