The 7.5% rule? – mean reversion in a range trading market

Posted on 05 March 2010

Interesting analysis from the Contrary Investor (click here)

Funny, I’m coming around to the same range trading view – that we oscillate between fear based on fundamentals and greed based on liquidity. That money printing and government stimulus (in its many and varied hues) is here to stay with the net result that equity markets will catch a bid on the inevitable downdrafts as new measures are brought into play.

So thought I’d play the same slideshow on the Australian equities market and see whether the 5% rule was a valid metric for our resource exporting economy.

The short answer is a resounding no. I haven’t taken the time to highlight the single recession (1990) that occurred during the period – as clearly our market is a whole lot more volatile than the S&P500. This could be partly to do with relative size and liquidity, but probably more importantly due to the higher resources component in our index. Resource prices are notoriously fickle and this is generally amplified through a mining company’s leveraged earnings (doesn’t mean to say that history will repeat – given lower gearing of the resources sector this time around and the ever present Chindia bid).

In any event, the 5% is looking more like a 10% rule (or at best a 7.5% rule). The point is still valid though – in a range trading market there is value to be had from trading at the extremes and one way to gauge this to ask how far is the market trading from its 50 day moving average.

One last point worth noting though – the key assumption here is that the market is likely to trade sideways. If it doesn’t (China decides to put up the shutters for example), then buying simply cause we are 10% below the 50 day MA isn’t a great strategy. For a quick visual check – have a look at the following chart in the light of the one above – if the market trends down, so does the 50 day MA…