The Force That Rules Markets
It's called reversion to the mean, and it explains all, from stocks to the Red Sox
By Jon Birger

(MONEY Magazine) – Steven Galbraith's final prediction as Morgan Stanley's chief market strategist was flat wrong—and he couldn't be more pleased. Early last year he wrote, "The Boston Red Sox are, in fact, cursed and will never win the World Series in my lifetime." Strange words from a lifelong Sox fan and a diehard believer in reversion to the mean, the force that eventually brings every anomalous run of events (from 86-year World Series droughts to eight-year bull markets) to an end. "The baseball gods needed to see a true believer give up the ghost," he jokes today, still giddy over Boston's first World Championship since 1918. Galbraith, now a hedge fund manager, spoke with senior writer and fellow Fenway fanatic Jon Birger.

Q. What, if anything, does the Red Sox victory tell us about investing?

A. It's the ultimate example of reversion to the mean, which I still think is the most powerful force in finance. But remember that what separates good investors from great ones is understanding the "when" of mean reversion. Some things take 86 years to revert. The more commoditized the business, the more quickly it reverts. The more idiosyncratic (baseball, for example), the longer it takes.

Q. Oil prices are in the stratosphere lately. Is oil a candidate for mean reversion?

A. We will mean-revert on oil, and commodities more broadly, and that's why I'd be leery of chasing any commodities now. But we need to recognize how long and how profound the underinvestment in energy has been.

Q. So $50-a-barrel oil is not necessarily an aberration?

A. For years, if not decades, we've invested too little in new production of oil, chemicals and commodities. Yet in tech and telecom, we've had the exact opposite. Look at how many analysts still follow Cisco [39] vs. a chemical giant like DuPont [15]. So while I don't expect oil and commodity prices to fall right away—we're probably in the sixth inning, not the ninth—prices will fall eventually, and it'll be ugly when it happens.

Q. What's your stock market outlook for '05?

A. It could be another tough year, though not a bloodbath. I think interest rates will go up, but not a ton. And I think international stocks will trounce domestic stocks. Back to mean reversion: We've still got eight years to unwind in terms of U.S. vs. non-U.S. stock market performance.

Q. And your Sox prediction? Based on your history, I hope you say they're going to stink.

A. The odds strongly suggest the Red Sox won't repeat—but, God, I hope they do.