Tuesday, January 19, 2016

All or Nothing

Just two weeks into the New Year and already a dismal pattern in equity markets where another Friday rout pushed nearly every sector and asset class into the red with U.S. small cap (or at least the iShares Russell 2000 Fund) and European equities slipping into bear market territory while the S&P 500 has now officially entered a correction, down 11.63% since its peak on May 20th.  Perhaps even more troubling is the “all-or-nothing” nature of these Friday sell-offs with only inverse and Treasury heavy bond funds closing in positive territory as investors rush to unload any long position. Normally, we’d rely on the ETFG Quant Movers Report or our Behavioral Top 25 list to provide insight on how investors were adjusting, but even that crystal ball has turned murky with China funds sharing space with utilities and health care names.

Shifts in our ETFG Behavioral Quant scores have long been a favorite topic of our Monday morning posts for a number of reasons but largely because price momentum is one of the key contributors to the overall score and provides a glimpse into the shifting dynamics underlying the market.  In business school you may have been taught that stock prices follow a “random walk” and that there’s no benefit to studying past prices.  It’s probably an open secret that nearly every investment professional does just that on a daily basis and that markets aren’t nearly as “efficient” as many in academia would like to believe.  College professors might be reduced to calling those generational explosions of tech stocks, of which the dot.com boom of the late 90’s was just the most recent example, just another case of “animal spirits” but that’s precisely why we so often turn to our ETFG Behavioral Scores to help shed light on how investors are reacting to market developments.  Last March, the Quant movers report helped identify that bank funds were beginning to see positive momentum (and subsequently outperformance), as the chatter about a potential Fed rate hike began to increase.  But when those same funds dominated our list of behavioral top scorers late last Fall, it became clear the move into bank funds was overextended.

Perhaps that’s what makes the current “schizophrenic” nature of the list so maddening as not only is there no clear trend or pattern, but the list is made of funds that seem diametrically opposed to each other.  The top behavioral 25 list seems to have nearly as many China and small-cap funds as it does utility and consumer staples products while the list of weekly quant movers is dominated by European and developed market equity funds including the iShares Europe ETF (IEV), Vanguard FTSE Europe (VGK) and the Vanguard FTSE Developed Markets ETF (VEA) despite the fact that all three of these funds closed just off their weekly lows at prices not seen since 2013!

This isn’t the first time the list has become so bifurcated and one reason why is that price momentum is just part of the overall behavioral scoring process, the other part falls under the headline of “sentiment” and includes implied volatility, short interest and the put call ratio, all of which you can review in the ETFG Quant Report.  It certainly isn’t price momentum that put those European oriented funds on that list as all three have composite technical scores close to their bottom decile. Instead it was their sentiment scores, typically high implied volatility or short-interest, as IEV has crossed into a bear market since its peak last May while VGK and VEA are both just outside bear market territory and it’s a similar story for the China funds such as KraneShares CSI China Internet ETF (KWEB) and the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS).  That high volatility and short interest can weigh down a fund during bad times…or lead to explosive outperformance when investors suddenly decide to embrace risk.

The other part of the list, made up of consumer staples and utility names, consists of funds whose strong price momentum can override the weak sentiment scores common to their asset class.  It’s been nothing but wine and roses for the utilities sector since last December with the Utilities Select Sector SPDR (XLU) up 3.27% since December 5th versus a 10% loss for the S&P 500.  In fact, if you re-ranked the Quant Report on either short or intermediate term momentum, nearly every utilities fund we score makes the top 20 although only two small funds have pushed their way into the Behavioral Top 25, the PowerShares DWA Utilities Momentum Portfolio (PUI) and the PowerShares S&P SmallCap Utilities Portfolio (PSCU).  Readers only taking a quick glance at our lists might conclude that the momentum shift for utilities is still in its early stages and decide to go all in just as the sector, like the rest of the broad equity market, was hit hard on Friday with XLU down .9% while funds with a smaller-cap focus, like the Guggenheim S&P 500 Equal Weight Utilities Fund (RYU), were down substantially more on the day and closed the week in the red.  In fact, XLU has the highest momentum score of any of the select sector SPDR funds but also has the lowest sentiment score thanks to its incredibly low short interest and tepid volatility which is why only small funds with a smaller average market cap weighting make the behavioral top 25 and perhaps not for much longer.  PUI was down over 2.7% last Friday on heavy volume several times that experienced on a normal trade day.

So where does that leave investors, besides between a rock and a hard place?  The ETFG Quant Report was designed with flexibility in mind so remember that you can manipulate the columns to find funds with low volatility and momentum scores not currently tracking new lows.  Preferred stock and a number of long/short and market neutral funds meet these criteria where the more adventurous might try the opposite tack of high volatility and come away with a list of MLP and China funds that could rally if the markets stabilize or investors become more discriminating in their selling.  But with a number of technical indicators like the Arms Index telling traders that equities might not be oversold just yet, staying cautious might be the smartest strategy.

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