circumstances will go up in the relatively near future? A guiding principle
of contrarian investment thinking is that what goes down will usually come
back up.
The concept is called “reversion to the mean,” and it usually appears
to work. However, while we are certainly contrarian in our buying
strategy, we do not hold the conviction that what is at play in most cases is
a reversion to any mean. Such a concept assumes that there is some kind
of “fair price” of the stock and while the actual market price may deviate
upwards and downwards, the stock always finds itself drawn back to that
fair value pricing point as if pulled by some kind of irresistible gravitational
force.
Our difference of opinion with this view concerns the existence of
such a mean price or fair anchor price. We see the dynamic of what appears
to be a reversion to the mean at work in most if not in all stocks,
but we feel that what is really going on is a simple, natural fluctuation in
price. Any fluctuation, of course, has its mathematical mean or midpoint,
but we do not feel that there is any force pushing the stock price toward
that price point other than a statistical coincidence. This difference of opinion
with the “reversion to the mean” crowd may just amount to a splitting
of hairs. After all, the resulting contrarian buy signal is the same—buy low.
However, in the interest of understanding better the mechanics that drive
prices in the market, the concept of “reversion to the mean” is better replaced
by a “theory of fluctuation.” This posits that individual stocks as
well as the overall market itself move in waves or cycles, which are evident
in the very short-term, medium-term, and over the long-term, too. As
short-term traders, it is the short-term fluctuations that we take advantage of.
Read More : The Theory Of Fluctuation
