Reversion to Something

Do stock index prices fluctuate around some value baseline? In his March 2001 paper entitled “Temporary Movements in Stock Prices”, Jonathan Lewellen investigates the degree to which stock market returns exhibit long-term reversion. Using data from the period 1926-1998, he concludes that:

• During 1926-1998, between 25% and 45% of annual returns in major market indices reverse over the subsequent 18 months. The percentage falls to between 10% and 15% for 5-year returns.
• Since 1945, between 20% and 30% of annual returns in major market indices reverse over the subsequent 18 months.
• Mean reversion appears to drop off for portfolios of the very smallest stocks and portfolios the very largest stocks.
• From a statistical standpoint, 1-year returns are the most reliable predictors of reversion. Five-year returns are strongly significant in the full sample, but not in shorter subperiods. Three-year returns are marginally significant predictors of reversion only after 1945.

In summary, stock market returns fluctuate away from, and revert to, a running mean on a roughly annual basis.

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