My recent post noted that historical patterns among markets can serve as useful heads-up signals for traders. That post examined extreme indicator readings and their implications for future price change in the S&P 500 Index. In this excursion, we'll take a look at a sector relationship: how the behavior of energy-related stocks--the Energy Sector Spyder ETF (XLE)--might be related to future movements of the large cap S&P 500 Index.
Thanks to a falling crude oil market, over the past 20 trading sessions, XLE has been down more than 5%. Going back to 2004 (N = 737 trading days), we've had 211 daily occasions in which XLE has been down more than 1% over a 20-day period. Ten days later, the S&P 500 Index (SPY) has been up by an average of 1.03% (161 up, 50 down). That is much stronger than the average 10-day gain of .05% (288 up, 238 down) for the remainder of the sample. It thus appears that falling energy markets are associated with superior near-term returns, perhaps because traders view such declines as helpful to the economy.
Indeed, that would seem to be the case. When XLE has risen by more than 5% during a 20-day period (N = 242), the next ten days in SPY average a loss of -.31% (113 up, 129 down). That is much weaker than the remainder of the occasions in the sample, which average a 10-day gain of .64% (336 up, 159 down). When energy is on the rise, markets have been performing subnormally in the near term. Knowing these sector relationships helps traders anticipate market movements, but also can help them understand when markets are not living up to their usual performance: useful information in itself.
In my next post, we'll examine yet another example of a historical pattern: this one linking entirely different markets.
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10 comments:
Wow! Great info as I have thought about that question.
So, things like XLE, GCS and even CGMFX can be viewed as a market hedge?
Hi Larry,
Because the energy stocks correlate with crude oil price, they have a lower correlation to the broad averages than do many of the sector ETFs. Of course, one could simply trade the commodities themselves as a hedge...The relationship between oil, gold, bond prices and stocks is worth exploring. Thanks for the comment--
Brett
I did some econometry on this issue and found that 25% of the variance of S&P 500 daily RETURNS can be explained by XLE dalily returns. On the weekly data, it is slightly higher number, which is quite significant statistical finding. BUT the relationship is positive, exactly when XLE index is up by 1%, SPY is up by 0.22%, and when XLE is down by -1%, SPY is down by -0.22% (on 1% significant levels)
Actually when I tried to look for the dependency of next 10-day S&P 500 returns on past 20-day XLE returns as in your post, I found very weak relationship, even if I used only mentioned 211 occasions. The correlation was -0.3, but it was not able to explain any portion of the variance, thus this result seems to be statistically insignificant.
There is no doubt that the energy sector has impact on the market (as well as gold, bond prices, etc.), but statistically, the results are not as strong as we would expect.
Hi Jozef,
Thanks for passing along your research. A correlation such as -.30 is not large in terms of explanatory variance, but can be a meaningful trading edge. That is why I count the number of up and down occasions, as well as the average size of the moves X days into the future. It gives a sense for whether or not there has been a directional bias going forward. I appreciate your stats re: the relationship between the variables. These are very relevant for developing actual trading systems.
Brett
Hi Brett,
Thank you for replying. I'm glad I can discuss with you online and learn something new again.
Yes I understand that what you're doing is finding the trading edge. I looked at the same period as you did, and compared next 10-day return of SPY after a 20-day decline of XLE with next 10-day return of SPY after a 20-day decline of SPY itself. Interestingly, I found no significant difference. When XLE has been down more that 1% over a 20-days, SPY has been up by an average of 1.05% (in 75% of occasions) 10 days later. Comparably, when SPY has been down more than 1% over a 20-days, SPY has been up 0.7% (in 67% of occasions) over next 10 days. Both results are much stronger that average 10-day gain of SPY (0.05%) for the period, and very similar results can be obtained when one looks at 10-day gain of XLE, when XLE (or SPY)was down by more than 1% over an 20-day period.
So what I'm trying to say is, that maybe SPY is up next 10 days after XLE 20-day decline of more than 1% just because of the fact, that during that 20-day decline of XLE, SPY declined also, so it is natural move in waves. That's also shown in my previous comment - relationship of energy sector and broad market is statistically positive, not negative as it may seem to be, and maybe market is rising after the decline in energy sector, but it might be just statistical coincidence?
Thank you, have a great weekend
Jozef.
Hi Jozef,
You make an excellent point. Because SPY rises following a decline in XLE doesn't necessarily mean that SPY rises *because* of the fall in XLE. We'd have to eliminate other variables, including the movement of SPY itself during the XLE decline, to establish causation. Thanks for the perspective!
Brett
Interesting. I had previously gone long on the QQQQ's. Following your posting of 'High Flux' and 'XLE', I made a conscious decision to be disciplined and hold, long-term, instead of my usual quick in-and-out.
Today's sell-off was alarming and, under other circumstances, would have caused me to sell in panic. But, with your analysis in mind, I was able to put things into perspective and realize that my position had decreased in value, but was not yet in jeopardy. I set appropriate stops and waited; sure enough, although the markets sold off TODAY, they were still up for the week. My option on the QQQQ's have now regained their value from closing, yesterday.
I would like to credit your posts for helping me to keep a clear, unemotional head and to remain analytical; not panic-stricken.
By the way, I've been doing some reading on HEG but can't find many peer-reviewed articles - just adverts. Do you have any sources?
Thanks. Sorry for being so long-winded.
Hi Bruce,
You're right; the literature on HEG to this point has been clinical reports, not controlled trials. It's very new and speculative, to be sure.
Your experience with holding the trade highlights the promise and pitfall of the longer-term holds: you can benefit from the broader, trending movement by riding out the noise, but you can get caught when the countertrend movements are more than just noise.
My problem with the bull case is that the rallies have been increasingly selective, with NASDAQ and small/mid cap weakness even as the Dow has made new highs. So what I end up doing in that case is only following the bullish longer-term signals if I also see evidence of buying from large traders during the day session. That's why I've been going home flat each day.
Bottom line is that we're all victims of our training and experience, and mine has been to read order flow and short-term market movements. I find it exceedingly difficult to hold a position if I see large traders going in the opposite direction.
That keeps me much more selective in the longer-term trades I take.
Thanks for the note--
Brett
Your point is well-taken. However, what I was most pleased with was the fact that I was able to remain calm, analytical, and able to form a plan of action based on data - not emotion.
If the market had not recovered, I would have been stopped out with a modest profit. This way, I gave myself the best chance for a better profit. Either way, it would have been the result of conscious choice, not panic/anger/greed/etc.
That's a great point, Bruce, and one that's relevant to any timeframe. It's much easier to stick with a position when you have a well-thought out rationale. That's what the research and intraday info on volume flow provides for me. Thanks for the excellent observation--
Brett
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