The answer to long term forecasting lies in mean reversion and its determinants, says Mukul Pal, CMT and Founder of a global alternative research firm.
One side behavioural finance uses an oscillating behaviour to disprove randomness and others use large fluctuations in an otherwise mean reverting behaviour to call the phenomenon unexplained.
“We redefined mean reversion as extreme reversion and connected outliers with it, explaining how outliers were happening across time frames”, says Pal. “The larger the time frame associated with an outlier, the larger the reversion expressed by the outlier. Even technically larger the previous price structure, larger the breakout, and larger the investment opportunity that outlier presents.”
Mean reversion
“Somewhere this outlier approach fits in with the dynamical systems (chaos, The strange Attractor) well because we just talk about reversion, we don’t talk about the pattern of reversion, whether it’s going to be in a zigzag or an impulse. Whether an outlier is going to outperform and become the best or whether an outlier is going to outperform, deliver average performance and stagnate.”
The answer to longer term forecasting according to Pal also lies in considering asset performance inter-connected with every holding period in a hierarchical structure. “This means that active and passive investing styles were also connected. This also meant that performances of global indices were connected as a part of the same group.”
“And any outliers among this group too were destined too revert. This is what we did. We took a large group of global indices and ranked them on quarterly performance.”