In my last post S&P 500 vs the Energy Sector I shared a theme that has worked very well navigating this bear market: using the relative performance between the S&P 500 and the energy sector (XLE) to trade the SPY. That theme has been added to the State of the Market report.
After a little more number-crunching, I discovered another sector that has exhibited a very similar (but different) tendency: consumer discretionary (XLY).
[logarithmically-scaled]
The graph above shows the result of going long the SPY at today’s close if the SPY underperformed XLY today, and going short the SPY if it outperformed, from 10/2007 to the present. The SPY is in blue, strategy results in green, and for comparison, the energy sector strategy is in red. This test is frictionless.
Note the difference between this and the energy sector strategy. In that strategy, the market outperformed when it led energies, but here it outperformed when it lagged XLY.
This strategy predicted 57% of all days correctly with winners 1.1x larger than losers.
Closing Thoughts…
Why does this strategy work? My readers know I don’t comment on fundamentals, but Dr. Brett has posted some interesting thoughts in the past on this relationship.
I’m calling this a theme (implying it’s temporary), because this relationship wasn’t consistent prior to the start of the bear market. But it’s been strong enough over the last year that I will be tracking it on the State of the Market report in the theme section to help us navigate these very troubled waters.
Happy Trading,
ms
P.S. Two other sectors exhibited a similar (but weaker) leader/laggard tendency: consumer staples (XLP) and retail (XRT). Also, the tendency was as strong as XLY in semiconductors (XSD), but this was the case long before the bear market began (read Semis Lead the Stock Market) and that strategy is already part of the SOTM report.
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Filed under: Stock Market Sectors, Trading Strategies | 3 Comments
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My email: michael @ marketsci.com (remove spaces)
If you eliminate the long trades in the strategy, the equity chart looks a lot smoother than if you have both, or if you simply short-sold every day (without the outperformance or underperformance condition).
RE to Hyper:
We are in the middle of a bear market (understatement). Of course a short-sell everyday or no-long strategy is going to outperform market since 10/2007. And if you can tell me when every bull and every bear market will begin, then I’ll only be on the long side during the bulls and only on the short side during the bears. But since we don’t know that, finding a strategy that’s able to play the bear despite being long half the time and short the other, and that (hopefully) won’t get short-squeezed when this market finally does turn around, is very powerful.
P.S. this is my same reply to your other comment as well. By your standard, no strategy would ever be good enough because it wouldn’t be as good as having perfect foresight of the market’s broader trend.
michael
I’ve tried something similar to this; using a ratio of XLY:SPY. The rationale for using the relative strength of XLY as a proxy for risk sentiment does make sense. I think you might get similar results if you used the relationship between SPY and a basket of high-beta stocks. In other words, the relative strength of more speculative stocks would probably tell you the same thing. I don’t know if the added complexity would add enough value to be worth it; XLY:SPY is probably good enough.
Josh