Mean reversion is one of the most powerful mathematical forces in the universe. (The “mean” is just another word for the “average”.)
In mean reversion, extreme or random events may take you one way – but then they usually revert back to normal, or the average, over time.
Mean reversion refers to the universal tendency of almost anything – luck, the weather, markets – to, with time, return to average, or normal, levels. You’re on a hot streak at the blackjack table? Great… but you’d better cash out soon because it won’t last. Has it been an unusually chilly winter so far? Chances are good it will warm up soon. Are markets on a roll? Enjoy it while it lasts, because the rally will eventually end.
The idea of “availability bias” is central to mean reversion. This is the tendency to pay too much attention to new or easily remembered information when making decisions. We remember that the chicken rice at that hawker center around the corner was good last time – even if it was cold and chewy the previous three times. We’re hardwired to evaluate risk at the “gut” level, rather than use our brains and process it logically.
The platinum-to-gold ratio
Mean reversion helps explain why the price of platinum is likely to rise in the coming weeks.
In recent years, though, this ratio has flipped. During the past five years, gold has been on average more expensive than platinum – five percent more expensive. The average platinum-to-gold ratio has moved from 1.35 over the past 30 years, to 0.95 over the past five years.
Over the past 30 years, the price of platinum (sometimes called “the rich man’s gold”) has historically traded well above the price of gold itself. On average, an ounce of platinum has cost 35 percent more than an ounce of gold.
This leads to an important caveat to the theory of mean reversion. Sometimes, there’s a structural change that forever alters the dynamic between two variables. For example, climate change might lead to summers that are hotter and hotter – and to every year boasting of a “record-breaking” hot summer. In this case, the mean never reverts. Instead, the mean is forever changed.
However, these structural shifts don’t happen very often. And the biggest danger is uttering those four dreaded words: “This time is different.” Perhaps it is… but mean reversion suggests that almost always, it’s not different. You just have to wait for mean reversion to kick in.
Perhaps the platinum-to-gold ratio is structurally lower, and won’t move above 1 again anytime soon, or ever. Maybe recycled platinum will be used more and more, which means more supply – and hence a lower price over time.
But even if that’s the case, right now the ratio, at 0.76, is almost lower than it’s ever been… it’s very close to 50-year lows. In late June, it reached a low of 0.74, before rebounding to 0.88… and rising 21 percent over the following five weeks.
Notably, the ratio has been around 0.76 for the past few weeks. Over that period, the price of platinum has moved up modestly – as has the price of gold, so the ratio has remained steady. In the coming weeks the platinum-to-gold ratio could increase if the price of gold falls and the price of platinum stays flat, or if the price of platinum falls less than gold. While both of these would cause the platinum-to-gold ratio to rise, neither would lead to a higher platinum price.
it’s more likely that the price of platinum rises in the coming weeks. “History doesn’t repeat itself, but it often rhymes” as American humourist Mark Twain may have said. And at around this level in the platinum-to-gold ratio in the past, platinum has risen.