Buy Europe on Reversion-to-Mean Trade

Wednesday, November 19, 2014 Buy Europe on Reversion-to-Mean Trade   by Jamie Dlugosch   Stock market action often follows the rules of statistics, specifically the reversion to the mean.   We know a coin flip is a 50-50 proposition, but in some sequences heads is flipped more so than tails. If given enough flips, eventually tails will make its way back to the average.   That doesn't mean in a series of flips with consecutive heads appearing that the next flip will be tails, but generally speaking the odds suggest that tails will come up eventually.   The same is true with stocks.   If a stock -- and that can be a class of stocks or entire markets -- moves above what the rest of the market is doing, chances are there will be a reversion to the mean.     FURTHER READING No matter where gas prices go -- you get paid   Gas prices have been moving down for a lot of the country -- thanks to fluctuations in crude prices. So finally, average American's are getting a little relief at the pumps. However, one group of folks are taking it one step further -- and letting big oil companies pay them to fill up. And believe it or not -- it's all part of an exclusive US Government program. And if you're eligible, you could collect up to $310 in Gas Rebates very soon.   Click here for all the details of this program.     Traders and investment managers will often use the reversion to the mean in making pair trades.   For example, take two stocks of similar nature like say PepsiCo (NYSE: PEP) and Coca-Cola (NYSE: KO).   For the most part one would expect these two very common stocks to trade in lock step. When there is a divergence, a pair trade can be placed with the expectation that there will be a reversion to the mean.   So if Coca Cola stock is going gangbusters and PepsiCo is lagging, the trade would be to go short Coca Cola and long PepsiCo.   Historically speaking, eventually the returns of both companies will come together and usually that is sooner than later.   JP Morgan put out a reversion-to-the-mean trade on Monday.   With U.S. stocks significantly outperforming Europe, the divergence is such that money can be made liquidating domestic equities and going long stocks in Europe.   JP Morgan put an underweight rating on U.S. stocks and a reverse buy rating on European stocks.   In October, European shares fell as investors speculated on a recession there with too weak of a response by the European central bank.   Since mid-October U.S. stocks have outperformed European shares.   In the opinion of JP Morgan, that underperformance is to be exploited with a long trade.   Analysts in Europe are projecting earnings per share growth that will exceed that of the S&P 500 fundamentals. That, in addition to statistics, suggests that Europe will be the big winner in coming months.   At least until the reversion to the mean is completed.   Helping push things along will be the strong dollar and weak euro trade.   That dynamic will increase the value of European sales done overseas further boosting earnings per share.   Investors might already be on top of this reversion-of-the-mean trade. After four straight months of withdrawals from euro-based exchange-traded funds, $117 million was added by U.S. investors in November.   That is still just a trickle.   To the extent euro flows become a stream, the reversion to the mean will almost become a self-fulfilling prophecy.   Because there are more and more investors playing the reversion-to-the-mean trade, you should as well.   In almost all cases the reversion to the mean works.   Jamie Dlugosch Editor Investor Research Institute   To Read More From Investor Research Institute Click Here
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