As Sam Sees It: Assessing the Stock Market’s Risk Tolerance

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Managing Director of US Equity Strategy for S&P Capital IQ, for his perspective on the current market.

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EQ: The market did not get the softness historically associated with the beginning of the sell in May period. Could the market be setting up for a pullback in June?

Stovall: Absolutely. The May through October period is traditionally the six-month period is the weakest of all 12 six-month periods of the year. However, it doesn’t mean that all declines have to start in May. There have been many times that we’ve had declines that occur in different months of the year.

In fact, going back to World War II, we have had two pull backs, one correction, and one bear market that started in the month of June. It is not among the most frequent periods in which we have had big declines, because only 5 percent of all declines started in June.

The month in which we saw the greatest number was October, followed pretty closely by May, July and August. So I would tend to say that the swoon usually does not start in June.

EQ: Looking at last year, we didn’t see a decline in May, but we did in June.

Stovall: We did. We saw a near 5-percent decline in June that started just after Fed Chairman Bernanke indicated that the tapering would begin sometime either later in 2013 or in the beginning of 2014. We did recover very quickly when investors realized that the only reason why the Fed would begin tapering is if they felt the economy was strong enough to withstand a reduction of the stimulus program.

Using the doctor-patient analogy, the doctor (the Fed) felt the patient (the economy) was strong enough to be taken off the intravenous feed.

EQ: The Technology sector led the best performers in May, most likely due to a rebound from the sell-off just prior. Does that skew the numbers, considering how large Tech’s influence has on the S&P 500?

Stovall: I don’t necessarily think it skews the results because most of the declines that were Tech related had a lot to do with companies that are not found in the S&P 500. They were your much smaller-cap social media companies that really took it on the chin. So the Technology sector is a very large component of the S&P 500, representing the biggest exposure at close to 19 percent. The second-largest sector is Financials at 16 percent.

Surprisingly, on a year-to-date basis, the best-performing group is Utilities, which is up 12 percent. In fact, only Consumer Discretionary is in negative territory. So we can honestly say that nine of the 10 sectors in the S&P 500 have contributed to the 4 percent gain through June 3.

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EQ: So it was nicely spread across the board. That’s a positive sign for the market, correct?

Stovall: It is because technicians like to look to breadth, which just indicates how many stocks, sun-industries or sectors are participating in this rally. If you have a wide number of companies and categories that are benefiting, then the thought is that if we’re firing on all cylinders and there are one or two cylinders that sputters, the engine can keep going.

So that’s why technicians typically look at the advanced decline line as well as the breadth indicators to make sure that there’s enough critical mass behind a market’s move.

EQ: In this week’s Sector Watch report, you discussed a few ways of gauging the market’s risk appetite. One of the ways you detailed would be using the High Beta and Low Volatility indices. How would an investor use this to their advantage?

Stovall: Historically, technicians have looked to the relative strength of the Consumer Discretionary and Consumer Staples indices. They divide the index value of the Discretionary group by the index value of the Staples group. It doesn’t really matter what the actual outcome is, but rather the trend of the relative strength overtime that people look to.

A rising line indicates that investors are more cyclically biased because we’re seeing stronger price appreciation for Discretionary. When a line is declining, then investors tend to be more defensive leaning because the more defensive Staples, like food, beverage and tobacco companies are outperforming.

So, I actually found that a better risk-on, risk-off signal was the relative strength of the S&P 500 High Beta and Low Volatility indices. In particular, from 1999 to the present, I wanted to see what happened when you were in the market when the two indicators showed “risk-on” periods, and in cash when the indicators pointed to “risk-off” periods. I found that the High Beta/Low Volatility signal did better than the Discretionary/Staples indicator.

If you invested $1,000 on Dec. 1, 1999, it would have grown to $1,300 for the S&P 500. Using the Discretionary/Staples strategy would have grew to about $8,800, and more than $12,000 for the High Beta/Low Volatility signal.

Of course, past performance is no guarantee of future results.

EQ: In these strategies, it looks at rotating into stocks or into cash. One of the topics we discussed before in regards to the sell in May period is a sector rotation strategy instead. Could you apply a sector rotation strategy to enhance those returns?

Stovall: Actually, that’s a very good point. If the market tends to do relatively poorly in the May through October period, but not poorly enough that you would want to sell in May and go into cash, you may want to just rotate into the more defensive sectors, then I would tend to say it’d be a worthwhile study.

However, since I have not done the study, I can’t say for certain that it would be better to rotate into the defensive sectors rather than out of the market as a whole when we get the risk-off signal, even during the more vulnerable May to October period.


DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

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