Price-Driven CMA models reject the notion that market returns are random outcomes like flipping a coin. When flipping a coin, the odds of heads or tails is always the same: 50/50. By contrast, Price-Driven CMA models assume that after a long series of positive returns (heads), the odds of a negative return start to increase. Similarly, after a long series of negative returns (tails), a positive return becomes more likely.
This type of behavior is known as “mean reversion.” Under mean reversion, a long series of returns in one direction, positive or negative, pushes asset classes to overvalued and undervalued levels. Overvalued asset classes have higher odds of a below average return that will push the asset class down to more normal valuation levels. Similarly, undervalued assets are more likely to produce an above average return that will push the asset class valuation back up toward its long term average valuation. Price-Driven models expect average returns only when valuation levels are close to average levels.
As with Static models, returns in a Price-Driven model may be significantly higher or lower than the expected return. The more volatile the asset class, the more returns can vary from expected return levels. However, a Price-Driven CMA process dynamically adjusts expected returns for the impact of changing prices and changing valuation levels. Put simply, higher prices lead to lower expected returns and lower prices lead to higher expected returns.
The chart below shows the historical support for Price-Driven CMAs. Adherents to Price-Driven CMAs acknowledge that short term returns seem to be almost random. However, long term returns like the 10-year returns in the chart below appear to show mean reverting behavior.
The chart plots 10-year large cap “real” return (returns after accounting for inflation) against the same distance from trend (DFT) measure used above for the 1-year return chart. Unlike 1-year returns, 10-year returns appear to show a distinct correlation with DFT. Historical periods that begin with DFTs of -40% or -50% (significantly undervalued) show much higher average 10-year returns (the red line) than historical periods that begin with higher DFTs. In fact, average 10-year returns have been negative for significantly overvalued historical periods (periods that began about 75% above the long term trend).
Adherents to Static CMA analysis point out that there have been very few completely independent historical 10-year return periods. As a result, the apparent connection between valuation and long term returns cannot be statistically proven. Adherents to Price-Driven CMAs argue that common sense is on their side.