Just because two items have had some historical relationship doesn’t mean it can’t change. Betting on reversion to the mean can be extremely dangerous when a paradigm changes. For a current example, check out this chart from Bespoke on the oil-natural gas ratio:
Source: Bespoke Investment Group (click to enlarge)
For years and years, it looks like this ratio has been contained in the 5x – 15x range. In itself, that is a lot of variability. Now the ratio has blown out to 43!
How do you know when a paradigm is going to change? That’s the problem—you don’t. Or you might only know in retrospect when your mean reversion trade completely implodes.
Relative strength investment is relatively resistant to paradigm shifts because it adapts and does not make any assumptions about what the relationship “should” be. It goes with the trend, until it ends. When the trend ends, it moves on to something else that is trending strongly. There is a lot to be said for limiting your assumptions!
