Risk-On But Mean-Reverting Forces Are Still Strong

High beta large caps are holding onto their gains after a recovery from significant losses earlier this year, while low volatility large caps show a mean-reverting tendency. The ensemble exhibits a fragile stability. The next more of speculators may be interesting.

In this article, the ensemble is SPY and the high beta S&P 500 ETF (SPHB) and low volatility S&P 500 ETF (SPLV) performances are used to reflect investor risk.

The chart below shows year-to-date performance of the three ETFs:

spy_splv_sphb_20161025

It may be seen from the above chart that SPY performance has been stable in last two months; SPLV shows a mean-reversion tendency and SPHB made a new high in the same period. The performance is summarized in the table below:

ETF Year Low Year High Year-to-date
SPY -10.3% 8.6% 6.7%
SPLV -5.3% 14.4% 7.4%
SPHB -21.0% 14.7% 11.4%

The significant recover in SPHB is evident from the table: from -21% early in the year to 11.4% year-to-date while SPLV fell only 5.3% earlier in the year but year-to-date return is 7.4%, or 4% below that of SPHB. Both SPLV and SPHB have about the same peak performance, 14.4% and 14.7%, respectively.

The above numbers tells us that during a year of high uncertainty investors increased risk. This started in July and peaked in the beginning of this month.

What the above could mean for the future direction of the market? Are these “risk on” investors “longer-term” or just speculative funds that drove prices of underperforming securities up to squeeze out cross-sectional momentum funds that buy best performing assets and sell worst performing ones?

The magic of the markets is that no one knows the true intentions of market participants and sometimes even they themselves do not the full ramifications of their actions. Therefore, it makes no sense to speculate about motives. The numbers in the table above suffice to describe the state of large caps. This state cannot be reduced to motives, i.e., the latter are unobservable micro-states. However, experienced investors and traders are often successful in anticipating the next move of speculators. I think in this case that can be done at high probability.

If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY

I am available for remote consulting in the areas of trading strategy development and analysis, asset allocation and trading risk management.

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