Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: Last week, we discussed how Consumer Discretionary is actually not as cyclical as many investors believe. In your most recent Sector Watch report, you addressed how the Consumer Discretionary/Consumer Staples relative strength indicator may have become less reliable in gauging the recent market. What is the CD/CS and why do some investors believe it may have lost its effectiveness?
Stovall: Basically, I’ve heard many times that technicians used to look at Consumer Discretionary and Consumer Staples stocks to help to decide what the “risk-on, risk-off” trend was. If the relative performance showed that Consumer Discretionary stocks–which consist of autos, home building, retailers–were outperforming the more defensive food, beverage, tobacco stocks found in the Consumer Staples category, the implication was that investors were willing to be more aggressive and focus more on cyclical stocks because the thought was the markets would work their way higher. Yet, I found that a lot of technicians believed this really has not been working all that well. They feel that it’s lost its effectiveness because so many companies in the Consumer Discretionary index could actually be regarded as fairly defensive, since one-third of the Consumer Discretionary industries, or about 40 percent of the weighting of the industries in this sector, have betas that are less than 1.0. This means that their volatility is less than the overall market. So the question became, “How can you have a bulk of the industries in a cyclical sector actually show defensive characteristics?”
EQ: Do you think the CD/CS issues are just a result of the current market environment or has the evolution and maturation of these consumer sectors created a more permanent perplexity?
Stovall: I think that it’s just the evolution of the index itself. Companies try to focus on what consumer demand. As a result of the economic slowdown, consumers are focusing on low-priced items. Even though restaurants or general merchandisers are traditionally found in a cyclical sector, during hard economic times, consumers will trade down to low-priced restaurants and low-priced general merchandisers, and away from the mid-tier retailers. However, I would tend to say that it might not be something that will remain with us forever, but certainly for as long as consumers are cost conscious and companies find that they can make money by focusing on providing low-cost products and services.
EQ: In April, Standard & Poor’s launched two new indices: the S&P 500 Low Volatility Index and the S&P 500 High Beta Index. Can you talk about the two indices and their purpose?
Stovall: So the thought was, should we try to compare two different sectors instead of Consumer Discretionary and Consumer Staples? Do we look to Technology, Industrials, etc.? But then S&P came out with two indices that probably serve a better purpose. The S&P 500 High Beta and the S&P 500 Low Volatility indices, as the names imply, are all stocks that come from the S&P 500. The High Beta group consists of the 100 stocks with the highest volatility, whereas the Low-Volatility group consists of the 100 stocks with the lowest volatility. In a sense, you get either end of the volatility spectrum. As a result, which is what investors are hoping for, they are now truly able to compare apples to oranges, rather than comparing oranges and tangerines.
EQ: So you did a comparison test using the CD/CS and the HB/LV. Based on your results of this test, which indicator proved better at signaling Buy and Sell opportunities in the market?
Stovall: I found that the High Beta and Low Volatility comparison did a much better job than the Consumer Discretionary versus Consumer Staples index at indicating whether risk-on or risk-off was the rule of the day in the market. Specifically, what I did was I went back to 1999 and in this hypothetical portfolio, I had the spreadsheet invest in the S&P 500 in those months in which the High Beta Index outperformed the Low Volatility Index. At the same time, I had the spreadsheet calculate investing in the S&P 500 when the Consumer Discretionary was beating the Consumer Staples sector. What I found going back to 1999 was that if you had invested in the S&P 500 by itself, your initial investment of $1,000 would have eroded to $833 as of Oct. 14, 2011.
Yet, if you had correctly invested in the market whenever the Consumer Discretionary sector beat the Consumer Staples sector on a monthly basis, your $1,000 became $5,630.
If you had correctly invested in those months in which the High Beta Index beat the Low Volatility Index, your $1,000 grew to $8,211. Basically, this High Beta/Low Volatility comparison outperformed the Consumer Discretionary/Consumer Staples comparison by an average of 350 basis points per year. Of course, we all know that past performance is no guarantee for future results.
EQ: What gave you the idea to compare the two volatility indices with the two consumer sectors?
Stovall: The Consumer Discretionary/Consumer Staples comparison has been out for a while, saying that when the indicator is up and Consumer Discretionary is doing better than Consumer Staples, the market is more willing to be cyclical in nature. If it’s going down, the market is a little bit tenuous and therefore you want to be a little more defensive. But, I did notice that there were five times since 1990 in which both consumer sectors either beat the market or were within 50 basis points of the market’s performance. That raised the question of how can both of these indicators beat the market when one is supposed to be defensive and the other is supposed to be cyclical? So when a colleague of mine described these two new indices to me, I’m always thinking of ways to apply to the strategies from my book, The Seven Rules of Wall Street, or just using it for rotational strategies that investors can embrace.
EQ: If investors wanted to invest in either of the volatility indices or the consumer sectors, are there any ETFs or other investment vehicles they can look at?
Stovall: Yes, there are ETFs out there that track these indices and sectors.
- For Consumer Discretionary, there is the Consumer Discretionary Select Sector SPDR (XLY),
- For Consumer Staples, there is the Consumer Staples Select Sector SPDR (XLP),
- For the S&P 500 High Beta Index, there is the PowerShares S&P 500 High Beta (SPHB),
- For the S&P 500 Low Volatility Index, there is the PowerShares S&P 500 Low Volatility (SPLV).
