Most broad market indices generally have 3 variations. The first variation is often called “Core,” and examples include the S&P 500 (NYSEARCA:IVV), the Russell 1000 (NYSEARCA:IWB), and the Russell 2000 (NYSEARCA:IWM). At the opposite ends of the spectrum are then what are called “style” indices. The two main styles are Growth and Value. The difference between these two is often related to the way that sectors are weighted. Generally, Value indices hold a bigger weighting in the Financial (NYSEARCA:XLF) and Energy (NYSEARCA:XLE) sectors, while Growth overweights Technology (NYSEARCA:XLK) and Consumer Discretionary (NYSEARCA:XLY).
The biggest difference between the two in terms of sector composition is each style's respective weighting in the Financials and Technology sector. See below for a comparison of the top 6 heavily weighted sectors, taken from the top 3 of the Russell 1000 Value (NYSEARCA:IWD) and the top 3 of the Russell 1000 Growth (NYSEARCA:IWF).
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What the above means is that a large amount of one style's outperformance relative to the other is explained by whether Financials are outperforming or underperforming Technology. Of course, we know from the financial crisis that banks have done poorly, while Technology has fared significantly better. But things may be starting to change. First, let's take a look at the price ratio of Financials (XLF) to Technology (XLK) over the past 3 years (remember this time frame as it is important). As a reminder, a rising price ratio means the numerator/XLF is outperforming (up more/down less) the denominator (XLK).
Let's zoom in on just the past year to get a sense of more recent performance.
Notice that Financials began outperforming Technology in late November as the trend in the relative price ratio picked up. While it should come as no surprise that simply because of the higher weighting in Financials, investors in most Value indices have underperformed both the Core and Growth equivalent over the past 3 years, it might be worth considering that Financials are now showing strength.
I mentioned that 3 years was an important time frame for a very real reason. Studies by De Bondt and Thaler indicate that positioning a portfolio in the weakest performers over the previous 3 years tends to outperform the market over the next 5 years. Inversely, the past winners tend to underperform substantially. This should come as no surprise since stocks and sectors tend to exhibit momentum in the short-term, but mean reversion in the long-term.
Russell 1000 Value/Russell 1000 Growth
Since the end of November, the Value style started outperforming Growth around the same time Financials started outperforming Technology. That trend looks likely to continue. The implication of this? Further market gains likely have to be led by Financials, as sector rotation takes hold and new sector leadership emerges away from Technology.
Disclosure: The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.