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Volatility has returned. After breaking an important medium term trend line on Friday (10/19), the S&P 500 (SPY) followed through Tuesday with a major gap down, breaking through its 50-day moving average and finding support at its April 2012 highs (see chart).


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The Nasdaq (QQQ) outperformed the SPY by about 0.5%, though continued its downtrend, finding support at its 200-day moving average and a major trend-line from summer 2011 (see chart).


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The CBOE Volatility Index (VIX) rose over 13% and sits above its 200-day moving average (see chart below).


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Despite the S&P 500's small consolidation bounce today, technical measures like the RSI and MACD do not yet look oversold and the VIX remains relatively subdued, suggesting that this correction may have further room to run.

Momentum and Reversal

Amid volatility, it is helpful for investors with an equity mandate - and who are inclined to tactical asset allocation - to step back and look at significant longer-term relationships to figure out how to position. Two such relationships are those of short-term momentum and longer-term reversal.

In excellent speech to the CFA Society of Chicago ("Asset Price Bubbles", May 2011), Dr. Werner DeBondt used long-term reversal and short-term momentum effects to group individual securities, asset classes, countries, sectors, styles and other investment strata into four main categories:

  • Cheap Winners - Underperformance over several years, outperformance over several months.
  • Cheap Losers - Underperformance over several years, underperformance over several months.
  • Expensive Winners - Outperformance over several years, outperformance over several months.
  • Expensive Losers - Outperformance over several years, underperformance over several months.

Of these categories, the best (most likely to outperform) from a momentum and reversal point of view are "cheap winners" and the worst are "expensive losers."

Note: Readers who would like to dig deeper can read DeBondt's article on style momentum (co-authored with Hsiu-Lang Chen) and various other articles on his website.

Cheap Winners/Expensive Losers: I looked for potential cheap sector winners by looking at the absolute performance of S&P sector iShares over the past 5-months (momentum) and 5-years (reversal), as well as their performance relative to the S&P 500 as a whole. I was looking for those sectors that had performed well over the past five months, but poorly on a five year basis.

Absolute Performance - From a long-term reversal perspective, of the nine S&P sectors, the four worst performing over the past five years (in order from worst to best) were Financials (XLF), Materials (XLB), Industrials (XLI) and Energy (XLE). The four best performing were Consumer Staples (XLP), Consumer Discretionary (XLY), Health Care (XLV) and Technology (XLK).


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From a short-term momentum perspective, the four best performing sectors over the past five months are Financials , Health Care , Energy and Materials . The four worst performing are Industrials , Utilities (XLU), Technology and Consumer Staples.


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The three sectors that are both in the bottom four over the five-year period and the top four over the five-month period are Financials, Materials and Energy. These sectors could be identified as potential Cheap Winners. Financials were the strongest of the group, as both the worst performing sector over the longer-term and the best performing over the shorter-term.

Two sectors - Consumer Staples and Technology - were both in the best performing group over the five-year period and the worst performing group over the five-month period, suggesting that they may be Expensive Losers.

With regards to the other two categories, Industrials and Utilities could probably be classified as Cheap Losers, given that both were in the bottom four, or on the cusp, for both the five-year and five-month periods. And, Health Care and Consumer Discretionary could be classified as Expensive Winners.

Relative Performance - The picture is similar from a relative performance perspective. Financials are still the worst performing sector relative to the S&P 500 over the five-year period - indeed, the only sector to underperform over that period (see first chart below).


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And, Financials are the best performing relative to the S&P 500 over the past five-month period, followed by Health Care and Energy.


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Trends in Relative Performance

To drill-down further, I looked at charts of sector performance relative to the SPY over time, as well as the slope of the trend in relative performance. The following table groups the sectors by economically defensive, cyclical or sensitive, according to their Morningstar categories, and then looks at the slope of the relative performance trend over the past year, as well as the recent change in that slope (see table).


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Interestingly, while two out of three economically defensive sectors have a positive trend slope - and all three have an increasing slope - Financials, Materials and Energy all have an increasing slope and Financials has a positive slope as well.

I present 10-year relative performance charts at the bottom of the article below, with sector charts displayed in the order from the table above.

Conclusion

The positive and increasing trends in outperformance for the defensive sectors, versus the S&P 500, support the view that the current correction may have further room to run.

However, the Financials sector - the top "cheap winner" from the momentum and reversal analysis - also shows a positive and rising trend in outperformance, despite being economically cyclical, and other cheap winners, like Materials and Energy, are showing potentially bottoming/increasing relative trends as well.

When volatility begins to subside, these cheap winners may be the best positioned to outperform the SPY in the medium term.

Appendix: Relative Performance Time Series


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Source: Cheap Winners: Sectors Likely To Outperform Based On Momentum And Reversal