Reversion To The Mean : The Theory Around Beta



Beta Maps:
This time we will discuss an important principle of trading called Beta (migration). The theory around Beta Maps goes like this. ‘The Market forgets, and the Market gets obsessed….’. In any Index, there is always one part that is ‘under-performing’, i.e. it is being ‘forgotten’. And there is another stock at the other end, which amplifies the underlying theme (i.e. bullish/ bearish) in the Market.

Disclaimer: This article was written originally in February 2012, so some data points may be outdated.

The Key Skill in  Tracking Beta

The key skill in tracking Betas is the manner in which you define it, and the construction of the average/ Index around which the Beta is measured. The Index is supposed to aggregate a correlation of assets or asset classes, some of which are logically obvious and even available off-the-shelf (like the Nifty). The Nifty, very sensibly, aggregates the leading stocks in the market, which account for the major part of the Market Cap (58-60% currently), Free Float (>70%), and trading volume (45% currently). This makes the Index a good surrogate for the entire market; over time, if enough people think so, it becomes so.

And since the Nifty is known to all, it would be a good idea to explain the Beta concerning the Nifty. However, the real benefit of this kind of ‘beta tracking’ will accrue if you structure your own ‘indices’ from the ground upwards. For example, how about a composite Index that includes a particular weightage of Nifty, Gold, Silver, and Dollar. You will get a certain ‘beta pattern’, which will bring home to you a mean-reverting pattern, which is unique to your understanding of the market. Trading the outliers, playing ‘contrarian’ to a pattern that shows one instrument going out of whack, will mean that you are betting on mean-reverting movements in your ‘Index’. This is not by itself a complete investment/ trading strategy, but it is a very good confirming indicator for the rest of your stock picking.

I use it even to generate leads on which stocks to focus on, based on the underlying belief that all the other (fundamental) factors remain the same, a particular stock will follow the ‘moods of the market’, i.e. there will be liquidity and sentimental factors that push and pull on the stock. In a big company, things don’t change so much overnight, although they do (change) dramatically over the longer term. A short-term (trading) strategy that bets on a ‘return to the mean’, will produce profits more often than not. However, prepare to be surprised by large movements as market expectations drive fundamentals (for example, RCom has been deserted by the market, and this alone will drive its fundamentals in a manner not clearly understood by us). Still, if used carefully, it can be a successful trading strategy over the short term.

Different Ways Of Calculating a Beta

For example, the period July- Sep 2011 saw huge (shocking) bearishness, which was amplified in Tata Steel (Beta 8, i.e. for a 5% drop in the market, Tata Steel dropped 40%). That is because the European crisis was the key theme during this period, and Tata Steel exemplified this theme. Tata Steel did not drop because the market dropped, BUT the Market dropped because of Tata Steel.
There are many different ways of calculating a Beta, and this word is not to be confused with the Beta (relative daily volatility) that you normally hear in the media. I use this word because it comes closest to a concept that is widely understood. As we go deeper into this, it is very important to remember this. For example, how we choose dates will decide what Beta figures we get, and what ‘migration pattern’ we see. If we choose the wrong dates to denote the various ‘themes’ of the market, we will get junk information that will positively mislead us.

The first period, 12th Nov 2010- 12th July 2011 saw a ‘classical bear market’ developing. During this period, Bharti and DLF were the underperformers. Bharti was downright profitable because the Beta finally ‘migrated’ (upwards) as the market fell. During this period, the market fell 18% from 6336 to 5196. After 12th Jan 2012, you can see the Betas ‘diverging’ again. Tata Steel has accelerated and so has DLF. Reliance and Bharti look like ‘migrating’ downward, i.e. they will underperform in a bullish market.

When there is a correction, the low Beta stocks will drop more, while the high Beta stocks will be volatile, but will outperform the market. At the next correction, the Beta ‘divergence’ will emerge and we will see the Beta lines diverge. The ‘train is not leaving us’, but the next train is coming in. The last train carried Tata Steel with it.

Limiting Downside On The Stock

A stock that takes off, also creates a large potential downside, because it gets populated with ‘weak hands’, who panic easily. Conversely, the absence of ‘weak hands’ creates a limited downside on the stock. You do very well when you have limited downside. There is no Bull or Bear Market; you just have to keep your downside limited to 20% and you will do well. An early bull market reduces the downside, but a late bull market (like 14th Nov 2011) creates a lot of downside risk. Since profits are a function of volatility (which is almost constant), your only cost is the Value at Risk (VaR) coming from the downside.

In the coming 2 years building up to the bull market, you will have to choose many low Beta punts and trade aggressively. The end of the Bull market does not necessarily mean the end of profits; you can short high Beta and buy low Beta, something I would not recommend just now. Defining the end of the bull market is going to be key; like in the case of Aug 2011, if you are shocked by a reversal, you will be in trouble. Meanwhile, we should map every Beta ‘migration’ or ‘divergence’ and trade down aggressively.

An early Bull market has a limited downside as ‘all boats rise with the tide’, so we should pick up the first ‘divergence’ and trade. However, we should not be surprised when the ‘divergence’ accelerates and the stock tanks to bear market lows in the middle of a bull market (like in Bharti, which went down below 2008 lows during the 2010 bull market). This happens when ‘weak hands leave a non-moving train and get onto the fast-moving train’, thus weakening the rally and increasing the Risk in the high Beta stocks.

All through this, the Beta Map is a safe, steady measure to reduce Risk through Bull and Bear markets. In the short run, it does not make the most money, but in the long run, it takes the least Risk.
Please find enclosed the Beta Map.

P.S. To understand this well, you should superimpose the Nifty chart on the above dates, to understand the significance of the choice of dates, in which to classify the ‘moods of the market’.



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