Sector is a factor that may influence the choice of going to cash, hedging, or doing nothing when entering a bear market. My previous articles gave examples for consumer staples, industrials, healthcare, and energy (last episode here). This one will focus on the S&P 500 materials sector.
For each sector in the S&P 500 universe, I defined a fundamental ranking process. My Materials Ranking uses only two fundamental factors. One of them is the EPS change last twelve months, in percentage. For the next part, I will use a strategy consisting of a 4-week rotation of the ten stocks of highest rank. It represents about one third of the initial list: there are currently 31 materials companies in the S&P 500 index. This is not one of my investing strategies, but a reference portfolio in materials using common sense and simple fundamental factors. I find it more relevant than using a market cap-based ETF like IYM or XLB.
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. 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 all cyclical sectors, the unprotected portfolio gives an unacceptable drawdown and volatility.
If the focus is on the return, timed hedging is the best solution. But for investors whose priority is limiting the risk in terms of drawdown and volatility, the simple market timing is significantly better (going to cash).
Here is the equity curve of the strategy with market timing (in red) compared with SPY (in blue):
This is a dynamic portfolio. On average, 1.3 stock changes every four weeks. Here are the three highest market capitalizations of the current portfolio:
The Dow Chemical Co
PPG Industries Inc.
International Paper Co
Paper & Forest Products
*Trailing 12 months, extraordinary items included.
Timed hedging is modeled here in a margin account, and margin costs are included. However, it can be executed without a margin account by selling 25% of the portfolio and buying a 3x inverse S&P 500 ETF. It gives the same protection as shorting SPY in a 1:1 ratio.
Unlike defensive sectors such as consumer staples and healthcare, it is necessary to time or hedge a portfolio in materials stocks to avoid heavy losses in bear markets. Timed hedging may bring a better return, but risk averse investors might prefer going to cash when a bearish signal is triggered. 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.
Additional disclosure: Past performance is never a guarantee for the future.