Biotech as a Leading Indicator of S&P 500 Returns

27Sep12

This is a follow up to CXO’s Distinctive Biotech Seasonality (h/t: The Whole Street).

Specifically, this a follow up to the end of CXO’s post which shows a tendency for the BTK Biotech index to lead the overall stock market by a month (i.e. positive BTK returns this month portend positive market returns next month).


[logarithmically-scaled, growth of $1, monthly-interval, frictionless]

The graph above shows the results of two strategies that go long the S&P 500 at the close on the last day of the month when BTK ended the month up either (red) or down (grey), and hold the position through the following month.

Results do not include transaction costs, slippage, or return on cash, and have not been adjusted for dividends.

On first blush it would appear that BTK has been a strong leading indicator of next month S&P 500 returns.

As a baseline, here is the same test, still trading the S&P 500, but also using the S&P 500 as the leading indicator. In other words, if the S&P 500 closes up (red) or down (grey) this month, hold the S&P 500 next month.


[logarithmically-scaled, growth of $1, monthly-interval,frictionless]

This second graph, our baseline, shows that over the last 17+ years there has also been a tendency for follow-through in the S&P 500 (i.e. up months portend stronger next-month returns than down months).

And because the S&P 500 and BTK are somewhat correlated, at least some of BTK’s prowess as a leading indicator is likely simply the result of that monthly follow-through.

But note how much smoother the equity curve is in the first graph versus the second. On the surface, it would seem that BTK is the much better predictor.

Let’s dig a little deeper (this is going to get a little wonky)…


[vol-adjusted monthly ret. = geo. avg. monthly ret. / std. dev. of monthly rets.]

This last graph shows the difference in the 5-year volatility-adjusted monthly return between months when the leading indicator predicted an up versus down month. BTK as a leading indicator is shown in red, and the S&P 500 as a leading indicator in grey.

If that didn’t make sense, just know this:

When the red line is above the grey line it means that BTK has been a more effective leading indicator than the S&P 500 for predicting next month S&P 500 returns.

The graph shows that BTK’s edge has been consistent over the last 17+ years.

Does that mean I’m sold on BTK as a leading indicator? No.

We’re talking about monthly returns, so we don’t have many data points to consider (just 214 months). And a lot of this strategy’s “success” is the result of doing a good job sidestepping the 2000-02 and 2008 bear markets.

But I think the idea warrants further research.

Other research ideas: does BTK lead in shorter timeframes (ex. daily or weekly)? Do other sectors exhibit similar relationships? Why is the cutoff necessarily whether BTK closes up/down – what about other thresholds like whether BTK closes X% up or down? Rather than look just at month-end values, what about using rolling 21-day returns in order to increase the number of data points?

Happy Trading,
ms

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One Response to “Biotech as a Leading Indicator of S&P 500 Returns”


  1. 1 Friday links: dysfunctional at times | Abnormal Returns

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