Don't Be Such a Mean Reversionist

Welcome to the Exponential Age?

I write this edition of the newsletter as a follow up to the previous one. In the previous newsletter, I discussed how we are likely currently experiencing a “melt-up” in markets, a situation in which asset prices rapidly inflate as investors pile into assets that are already very overpriced. This “melt-up” is usually followed by a monumental crash. However, there are some that argue that this is an antiquated way of looking at the market, that those who expect this notable correction are simply being “mean reversionists”. Before I get into an argument made by a significant financial analyst who warns against being a mean reversionist, let’s first discuss what mean reversion is.

Mean reversion, or reversion to the mean, is a theory used in finance that suggests that asset price volatility and historical returns eventually will revert to the long-run mean or average level of the entire data set. Yes, I know, that still sounds kind of complicated. In layperson’s terms: even though prices of assets go really high (or low) at some points, they will always come back to “normal” or “average” levels. This idea of things returning to their normal levels, or “regression to the mean”, was first conceptualized in the mid 1800s by Sir Francis Galton, a British statistician and polymath, who, in conducting linear regression analyses, discovered that while there are outliers in behaviors or occurrences, there is an average to which these behaviors or occurrences always revert back. An example of this might be that someone has run three miles per day, every day, for years. They are comfortable with this distance; running this distance makes them feel good. The few times that they have run more (or less) just didn’t feel as sustainable or satisfying. Then, they discover a new sports drink, loaded with sugar and caffeine, which, all of a sudden, propels them to start running six miles per day for a few days. They feel like a million bucks until their neighborhood grocery store runs out of this sports drink and they subsequently crash hard. They are barely able to run their “normal” three miles per day for a few days after that. Once, they recover though, they realize again that the three miles per day was just right for them and they resume running that distance. That three miles is their mean, and they had reverted back to it by the end of this story.

In financial markets, these sorts of scenarios play out, as well. They are called bubbles. The difference between the story of the runner that I just shared and trends in financial markets is that while the “three-mile per day” line in my story is a horizontal line, the average line in markets is probably varies between a 30 and 45 degree slope. However, we’ve seen trends in the market in the last year that have the market moving at an almost vertical slope. Hence, the calls for the “melt-up”. It’s all just been too much too fast, and you can think of the Fed as that highly sweetened and highly caffeinated sports drink. In reality, it doesn’t take a rocket scientist to call for the market to correct significantly in the near future, but it does take a pretty forward-thinking cat to warn against thinking that the market will revert to its old mean and to beg us to try to look at the current market scenario with a new framework.

Enter Raoul Pal.

Raoul Pal is a global macro investor, business cycle economist, investment strategist, and economic historian (all according to his Twitter profile). He spent years working for investment banks like Goldman Sachs before starting Real Vision in 2014. Real Vision is a platform on which Pal and his associates interview visionary leaders, “experts” (I don’t like this word), and analysts who provide highly specialized insights on all different types of financial markets. I cannot overstate just how enlightening Real Vision has been for me. It is one of the greatest educational resources I have ever discovered - on any topic. While a subscription to Real Vision does cost a few bucks, a subscription to Real Vision: Crypto doesn’t. If you are interested in learning more about cryptocurrency, I cannot think of a better place to start. If you are interested in learning more about markets in general, spend the few bucks on a subscription to Real Vision.

Recently, I listened to two different interviews (below) with Pal, both in which he cuts off the interviewer as they begin talking like a “mean reversionist”.

He begs the interviewer to stop being so cynical, to stop calling for corrections in the market just because the market seems overvalued as per P/E ratios, which are, according to Pal, an antiquated metric for assessing value in the market. In the second interview listed above, Pal goes on to discuss how cryptocurrency, FAANG(M) stocks, and the Nasdaq have been the big winners coming out of the March 2020 crash. He claims that we have “network effects” or Metcalfe’s Law to thank for this. Metcalfe’s Law stipulates that we have to look at the value of an entire (computerized) network as a means of assessing value. Pal argues that it is the fact that so many people do not understand Metcalfe’s Law and resort to being mean reversionists that causes people not to hold stocks like Amazon or Tesla all the way up. While mean reversionists have claimed for years that Amazon is overvalued as per its P/E ratio, those who understand network effects understand that while Amazon may be overvalued by old metrics, it has more users than any other Ecommerce site, which, in other words, means it has the strongest network effect and is therefore valuable beyond the scope of old metrics. Pal argues that someone like Cathy Wood, CEO of Ark Invest - someone who understands network effects - continues to get it right as she calls for higher Tesla prices while “old men who like to rail at the internet” continue to get it wrong by betting against Tesla. Both cryptocurrency, FAANG stocks, and the Nasdaq are driven by underlying technologies that rely on network effects, and, therefore, in valuing these entities, we must shift the way in which we think about them.

Pal argues that we have to “change the denominator”. (I am still trying to conceptualize exactly what this means. I am beginning to get it, but I don’t know exactly which number should go in the denominator of the equation, and which number was there to begin with. If anyone can explain it, please feel free to do so in the comments. I would greatly appreciate it.) While, as I just stated, I do not entirely grasp this concept, if think it is safe to say that Pal is asking to consider new methods of conceptualizing and assessing value as we move into what he calls the “digital renaissance”.

Personally, I am still a bit of a skeptic, as I am only beginning to allow my space in my brain for this new type of thinking. I still believe both the traditional market and the cryptocurrency market will correct, but I also believe that after the correction, both Bitcoin and the Nasdaq (and maybe the FAANG) will lead the charge upward again thanks to Metcalfe’s Law. Regardless, I am thankful to Pal for sharing such illuminating thoughts in these two interviews and in the seemingly endless amount of insightful interviews hosted on his platform, Real Vision. I plan to continue thinking through the idea of P/E ratios vs. network effects (i.e., old ways of assessing value vs. new ways of assessing value) in future editions of the newsletter, but for now, I will leave off here with the following quote from Pal, as I believe it genuinely calls for us to at least be a bit less cynical, and to at most be wildly optimistic.

“We don’t live in a mean reverting world anymore; we live in the exponential age.”

-Raoul Pal

Best,

Frank

Twitter: @frankcorva

Currently Reading: The Sovereign Individual: Mastering the Transition to the Information Age, by James Dale Davidson and Lord William Rees-Mogg

Raoul Pal @RaoulGMI

Yes, there is a bitcoin revolution but there is a digital asset revolution going on that is beyond incredible. It is very early days, like BTC in 2013, but it's happening. Some will be on the BTC blockchain but the vast majority will not be. 1/