Taking a contrarian perspective can often be the right strategy with commodity markets. Taking the maxim ‘the cure for high prices is high prices’ and its antithesis then there will come a point in any market that momentum reverses and prices return to (or at least towards) the mean.
In this post we introduce one way of calculating the potential for mean reversion that uses the z-score. A z-score is simply the number of standard deviations separating the current price from the mean price. The strategy then looks at the momentum of the average z-score and takes a contrarian approach to trading to generate buy and sell signals. If the z-score is positive, it means that the current price of the security is above its mean. Correspondingly, if the z-score is negative, the current price of the security is below its mean. Although most trading packages calculate it, click here for how to calculate it in excel.
In JP Morgan’s latest Guide to the Markets 4Q 2016 they calculate the z-score for a range of different commodity markets and individual commodities looking at prices over the past 10 years. While the z-score for silver and gold are around zero suggesting that those markets are fairly valued, other markets, particularly livestock and industrial metals are close to their lowest level z-score. All of which might suggest the latter two markets may start to mean revert.