Sectors are some of the factors that may influence the choice of going to cash, hedging, or doing nothing when entering a bear market. Previous articles in his series gave examples for a consumer staples portfolio (read here), an industrial portfolio (here), and healthcare (here). This one will focus on S&P 500 Energy stocks.
For each sector in the S&P 500 universe, I defined a fundamental ranking process. My Energy ranking's main factor is the price-to-book ratio. For the next part, I will use a strategy consisting of a 4-week rotation of the ten stocks of highest rank among 44 energy companies currently in the S&P 500 index. The aim is not an optimal strategy, but a portfolio based on common sense and simple fundamental factors. I find it more relevant than using a market cap-based ETF like IYE or XLE.
I have performed three 15-year simulations (1/1/1999-12/14/2013): without protection ("NP"), with market timing ("MT") and timed hedged ("TH"). The portfolio is rebalanced every four weeks. The timing indicator is the same for market timing and timed hedging. It is defined by a bearish signal when the S&P 500 current year EPS estimate falls below its own value three months ago, and a bullish signal when it rises above this value. This is an aggregate fundamental indicator. There is no technical analysis here. The hedge is an S&P 500 short position in a 1:1 ratio with the portfolio value.
The next table shows simulation results. Dividends are included, transaction costs are 0.1%. A 2% annualized carry cost is applied for temporary hedging positions.
Like Industry, Energy is a cyclical sector: the unprotected portfolio gives an unacceptable drawdown and volatility.
Market timing (going to cash) and timed hedging give similar drawdowns, with a lower volatility in the case of market timing.
The timed hedged version is the best solution regarding total return and risk-adjusted performance (Sortino ratio).
Here is the equity curve of the strategy without protection (in red) compared with SPY (in blue):
This is a dynamic portfolio. On average, one stock changes every four weeks. Here are the three highest market capitalizations of the current portfolio:
Oil, Gas & Consumable Fuels
Oil, Gas & Consumable Fuels
Energy Equipment & Services
*Trailing 12 months, extraordinary items included.
Timed hedging is modeled here in a margin account, and margin costs are included. However, you can execute it without a margin account. Just sell 25% of your portfolio and buy a 3x inverse S&P 500 ETF. Doing so, you have the same protection as shorting SPY in a 1:1 ratio.
Unlike the healthcare and consumer staples sectors, it is necessary to time or hedge a good energy portfolio to avoid heavy losses in market downturns. Timed hedging may bring a significantly better performance and a lower correlation with the benchmark. If you don't want to miss my next article about another sector, click on "Follow". Additional sources of information are available in my profile.