Recurrence of ETF Sectors During Recent Severe Market Declines

Summary: There was a recurrence of outperforming and underperforming ETFs during recent sharp market downturns. These ETFs when categorizes into sectors were those which investors seem to believe were vulnerable to economic stresses: financials, oil & gas and real estate. Those sectors with their mirror ETFs (short ETFs versus long ETFs in the same sector) generated a wide daily return spread, i.e., if one were “long” the short ETFs and “short” the long ETFs in the same sector on those days the market experienced a severe decline. Given the tendency of ETF sectors to reappear during subsequent severe market downturns, it may be profitable to track the appearance of new sectors during such downturns. Such newly appearing ETF sectors and their counterparts may reappear in subsequent near-term market declines with similar favorable return characteristics.

Period of Volatility: 2008 will be remembered as a year of extreme volatility. The CBOE Volatility Index (^VIX) remained above 50 for most of the current 4Q. Since the beginning of the year there have been 25 incidences of the S&P 500 experiencing a daily price change of 4.5%, as measured by the SPDRs ETF (SPY). All such occurrences have been logged since the beginning of September. Not surprisingly, over 70% of the moves have been to the downside.

I was curious to see if there was a recurring pattern of stock price movements for ETFs during those days the S&P 500 moved down 4.5% or more. I looked for the outperforming and underperforming ETFs that appeared at least twice during those days to determine if the same ETFs reappeared and to establish if there was any relationship between the top winners and the losers.

Observation Period: I recorded those top ten outperforming and underperforming ETFs from September to October.The study period encompassed 5 of the 11 down 4.5% or greater days for which I had readily available data. In addition to being either in the top or bottom 10 on those days, I screened the ETFs for those that traded at least a million shares a day so there was ample liquidity for trading purposes.

Given the criteria, there were 23 occurrences of ETFs that appeared in the top 10 while 18 appeared in the bottom 10. There were 8 ETFs that appeared more than twice in the top 10 gainers and 3 ETFs that appeared in the top 10 losers. As one would expect in major market swoons, most of the top performing ETFs had “short” investment objectives, while the losers had “long” investment objectives.

Matching the winners and losers by ETF categories, there were 3 categories that continued to surface during these down days (illustrated by the chart above). They were oil and gas, financials and real estate. Not surprisingly, these were categories considered by investors to be some of the weakest. Not surprisingly, the categories’ mirror investments (short versus long) negative performance was somewhat similar to the positive performance of its counterpart (see chart below).

Observations: It would appear that investors have a tendency to gravitate to investments strategies that have previously worked during previous, significant market declines--particularly during high frequency periods. There also appears to be an opportunity to “long” the shorts and “short” the longs as the investment spread appears wide enough to be modestly late to the party.

Caveats: The observations beg the question of anyone’s ability to discern days in which the market would experience a large decline. The unlikely recurrence of days the market is severely down during a truncated period such as we’ve recently experienced. Additionally, the sectors that are in currently in disfavor will change over time with changing economic circumstances. Lastly, the study period of a month may not be reliable for extrapolation.

Having made all such disclaimers, it would appear that the likelihood of the same sectors reappear in large market declines may be worthy of note--particularly if a new sector appears on the radar screen and it can be associated with emerging negative investor sentiment.

Comments

[Wez:]

You have ure and uyg switched.

2008 Nov 25 12:13 PM

[Joe Eqcome:]

Wez, Thanks for the catch.

2008 Nov 28 06:43 PM

[fkhanmd:]

You also have SKF and SRS switched! ;-)

2008 Dec 01 11:01 PM