Mean Reversion

What Is Mean Reversion?

Mean reversion is the phenomenon where a variable that has moved significantly away from its historical average tends to move back toward that average over time. The intuition: extreme states are inherently unstable, and the same forces that drove an extreme departure tend eventually to reverse.

In statistics, this was first described by Sir Francis Galton as "regression to the mean" — he observed that tall parents tend to have children shorter than themselves, and short parents tend to have taller children.

Mean Reversion in Financial Markets

Interest rates: Real interest rates have a natural equilibrium (r*). When rates are far above or below this, economic forces push them back. This is why rate hiking cycles are always followed by cutting cycles.

Credit spreads: HY spreads have a historical average of ~400–500bps. When they reach 800–1000bps (as in 2008 or 2020), they tend to tighten back toward average over subsequent months or years.

Equity valuations (CAPE): When the Shiller CAPE ratio is well above its ~17x average (e.g., 35x in 2021), long-run expected returns are low and eventual reversion is expected. However, the timing can be years or decades.

Volatility (VIX): VIX has a long-run average of ~19–20. After spikes (COVID: 82, GFC: 89), it reliably reverts to lower levels. This is one of the most robust mean-reversion patterns in markets.

Currency pairs: Exchange rates are influenced by purchasing power parity (PPP) and interest rate differentials — both mean-reverting forces over long periods.

Mean Reversion Trading Strategies

Pairs trading (stat arb): Two historically correlated assets (e.g., two oil companies) diverge → buy the underperformer, short the outperformer, profit when the spread closes.

VIX mean reversion: Sell volatility (sell options) when VIX is elevated, expecting it to revert lower. Profitable on average but with catastrophic tail risk in vol spikes.

Credit spread compression: Buy HY bonds when spreads are historically wide, expecting spread compression as the cycle turns.

Why Mean Reversion Fails as a Simple Rule

The critical caveat: the mean can shift. If the structural level of interest rates rises permanently (a higher neutral rate), the old mean is no longer relevant. Similarly, if economic growth permanently re-rates equity valuations, CAPE comparisons to the 19th-century average are misleading.

The phrase "this time it's different" is usually wrong — but occasionally it's right. Mean reversion traders who ignored regime changes in interest rates in the 2010s bought "cheap" bonds that kept getting cheaper for years.