Semiconductor Leader/Laggard Strategy: A Flaw in Logic?

23Jul09

Warning: more extreme geekiness ahead.

In my previous post I looked at a flaw in the logic of some strategies that use the relative performance of two assets to trade just one of those assets (ex. using the strength of the dollar versus the S&P 500 to time the market).

In this post, I want to look at a relative-performance strategy we’ve talked about before, the Semiconductor (SOXX) Leader/Laggard Strategy, and whether it also falls victim to this flawed logic.

[logarithmically-scaled]

First, a refresher on the strategy. The graph above shows, in green, the results of going long the S&P 500 index at today’s close if the Semiconductor Index (SOXX) outperformed the S&P 500 today, versus buy & hold in blue, from May, 1994 to the present. This is a long-only strategy.

For comparison, I’ve also included the inverse of the strategy, going long if SOXX underperformed, in red. Geek note: this is a proof of concept, so these results are frictionless (i.e. do not account for transaction costs, slippage, or return on cash).

At first glance it appears that the strategy is fairly effective (at least at protecting against downside risk), and implies that a strong semiconductor index portends positive next-day stock market returns. But as we saw in our previous post that might just be a result of the stock market’s tendency towards daily mean-reversion.

So in the next two tables I’ll break down next-day results into four scenarios based on (a) whether the S&P 500 closed up or down today and (b) whether the SOXX outperformed or underperformed the S&P 500 today. Because of the evolution in daily mean-reversion around the turn of the century, I’ll run two tests: (a) pre-2000 and (b) 2000 to the present.

In each of the two data sets, we see the two competing influences.

First, prior to about 2000, up days on the S&P 500 tended to be followed by up days (and vice-versa). In 2000 and beyond that flipped contrarian and up days now tend to be followed by down days (and vice-versa). No surprise here – we’ve covered this evolution ad infinitum (read more here and here).

But notice that regardless of the S&P 500’s closing direction, returns tended to be stronger in both data sets when the SOXX outperformed the S&P 500 than when it underperformed. It didn’t necessarily mean next-day returns were bullish, just stronger than otherwise. So it would appear that there might be something to SOXX leadership, but the real question is whether or not it makes for a sufficiently effective strategy absent other inputs.

I’m reversing my original position and saying no, in its current form it does not. The semiconductor leader/laggard strategy is too overwhelmed by what the S&P 500 does to really be effective.

Last note: the logical next step is to take a scaled approach where, for example, an S&P 500 close down combined with semiconductor outperformance takes a stronger bullish position than say an S&P 500 close down with semis underperforming. More to follow on this (potentially curve-fitting) angle.

Happy Trading,
ms

 

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Filed under: Follow-Through, Stock Market Sectors, Trading Strategies   |  2 Comments