QQQ And SPY: A Case For Mean Reversion

Includes: QQQ, SPY
by: Andrew Corn

There are times when investors explore mid-term market moves seeking clues for where ETFs are not behaving at their historical norm. Right now one needs to look no further than two of our three main US broad market gauges; the S&P 500 as measured by its tracking ETF SPY NYSEArca and the NASDAQ as measured by its tracking ETF QQQ NasdqGM.

I deploy ETFs for quick exposure to a sector, region, or asset class and use them extensively for that purpose as added beta or a hedge. As an example I am usually long or short USO and CRUD in addition to my other single stock energy investments. The price of oil has been so range bound, this trade has been a source of alpha for months. But right now let's examine much larger and more liquid opportunities.

Since the market bottom in March of 2009 and through in and out of sample tests, QQQs generally out-perform SPY. The QQQs are presumed to be comprised of faster growing technology and mid- and small-capitalization firms. This composition of index constituents tends to produce more outliers which move the index faster with slightly more volatility. In a flat or up year one tends to be paid for that volatility with greater returns. Since the market’s bottom in March of 2009 the outperformance of the QQQ to SPY is over 20% on an absolute basis. The question is: are there times to best capture the out-performance?

In Q411, on price return, the SPY well out-paced the QQQ in what may be a set up for mean reversion.

As analysts reduce their estimates for S&P 500 companies, some estimates are being raised for these QQQ-based technology and smaller firms. This dispersion of estimates can add to the probability of positive outliers in the underlying index in this earnings season. Chalk it up to the perception of entrepreneurism, growing markets, or reduced costs, the QQQs have the potential to outpace the SPY.

Since the calendar has turned, the QQQs have taken an early lead. YTD the QQQs are trouncing the SPY. Measuring on a three month or even one month basis from today, the opposite remains true. Does this spell opportunity to have returns revert to their historical norms? Have the indexes begun their march back to their historic mean? If so, is long QQQ and short SPY a solid market neutral alpha trade? Or perhaps can my long-only readers simply overweight their QQQ position to their SPY and still benefit?

The charts show a disparity from historical norms. If accurate, the two week outperformance will continue until the QQQs return to their leading position. But readers beware, perhaps three months is not a long enough timeframe for mean reversion to be material enough for a targeted trade. At least for now, I am slightly longer QQQ than SPY.

Disclosure: Mr. Corn is CIO of E5A Funds LLC. He manages a global long/short and designs funds of ETFs. In his long/short he may be long or short broad market ETFs such as QQQ and SPY at any time. Currently he has no position in CRUD or USO and may be long or short these ETFs at any time.