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: In this week’s Sector Watch report, you highlighted the Cyclical Six, which sounds like a new superhero movie. What exactly is this investment strategy?
Stovall: I think investors might “marvel” at the performance of the Cyclical Six. It’s refers to the best six months of the year, as first introduced to me by The Stock Trader’s Almanac. Since World War II, the S&P 500 has gained almost 7 percent from November through the end of April, but just a shade under 1 percent from May through October. A lot of investors do wonder, though, if they really want to sell in May and move out of stocks altogether, and that’s a subject for another conversation. Investors have done much better by rotating into the defensive Consumer Staples and Health Care stocks rather than going into cash entirely or sticking with the market as a whole for the entire year. However, now that we are approaching the beginning of November, the question comes back to when sell in May goes the other way. So the Cyclical Six simply refers to those six months of the year where the market has recorded its strongest price performances as well as frequency of advance.
EQ: There are several ways to implement this rotational investment strategy, including using sector ETFs. Can you tell us more about a few of them?
Stovall: What I found was that since 1990, if you adopted a defensive approach in the May through October period by gravitating toward Health Care (XLV) and Consumer Staples (XLP) for the S&P 500, it actually added 400 basis points per year to your overall portfolio. So the strategy being that if you were in the S&P 500 (SPY) from November through April, but then rotated into Health Care and Consumer Staples from May through October, instead of getting 6.8 percent as a compound rate of growth, you got 10.8 percent. What I also found was that this was not a strategy that worked exclusively for large cap U.S. stocks. It also worked very nicely for the S&P 500 Equal Weight (RSP), the Small Cap 600 (IJR) and the Global 1200.
Then I’ve had people ask that if you could do well by being defensive in the summer, why not be a little more aggressive in the winter? I found that the Materials (XLB) and Industrials (XLI) sectors performed the best going back to 1990, but since there are a variety of cyclical sectors, I’m a little leery of simply going into those specific cyclical sectors, whereas I’m much more comfortable going into the traditionally defensive areas of Consumer Staples and Health Care during that risk-off period.
EQ: How about using the two newer indices from the S&P 500, the High Beta and Low Volatility?
Stovall: Absolutely. In the past year or so, S&P introduced the S&P 500 High Beta index (SPHB) and the S&P 500 Low Volatility index (SPLV). Each one consists of companies from the S&P 500 and there is no overlap. The High Beta index consists of the 100 stocks with the highest trailing 12-month standard deviation, whereas the Low Volatility group consists of the 100 stocks with the lowest trailing 12-month standard deviation. So I employed the High Beta index during the risk-on period of November through April, and then the Low Volatility index during the May through October period. Going back to April of 1997, which is as far back as we have for these two indices, while the S&P 500 gained an average of 6.7 percent from November through April, the High Beta index gained an average of 10.3 percent. From May through October, while the market declined an average of 0.4 percent, the Low Volatility index advanced an average of 2.4 percent. So once again, this semi-annual rotation strategy provided you with much better returns for the high beta benchmark for the S&P 500 as well as for the S&P International Developed (IDHB) and the S&P Emerging Market (EEHB) indices. This was also true for the Low Volatility components of the S&P 500 International Developed (IDLV) and Emerging Market (EELV) indices.
So if you wanted to engage in a seasonal rotation pattern by owning the High Beta component of either large cap U.S., Developed International, or Emerging Markets stocks from November through April, and then rotate to Low Volatility stocks during the risk-off period of May though October, then no matter where you are in the globe, at least since 1997, you would have ended up with significant outperformance. Of course, remember that past performance is no guarantee of future results.
EQ: How can investors learn more about the corresponding ETFs to implement this strategy?
Stovall: The S&P 500 High Beta, Low Volatility, as well as the S&P International Developed and Emerging Markets versions of High Beta and Low Volatility indices are all available in ETF form, and you can learn more about them by being a subscriber to advisor.marketscope.com.
EQ: As of Oct. 23, about 28 percent of the S&P 500 companies have reported earnings so far for the third quarter, and as expected, it has not been the prettiest season so far. Have any of the developments changed your outlook or opinion regarding the market going forward?
Stovall: Yes, I think it appears that Wall Street underestimated the third quarter earnings period and in some ways, it’s a little bit perplexing. Heading into the third quarter earnings period, S&P Capital consensus estimates called for a near 2-percent decline in earnings, yet the most recent report shows that actuals plus estimates are pointing to a slight positive year-over-year percent change. The one thing that has come down is revenue growth, and most of the commentary regarding forward guidance has been reserved, cautious, or whatever other euphemism you want to give it. So whether this was just a convenient excuse to take some profits based on the market’s performance in June of this year, or whether investors truly are concerned, at least at this point, the S&P 500 has been experiencing an at least 3.5-percent decline. I don’t believe that we are going to go much beyond a 5-percent decline, which is a needed digestion of the recent advance. However, certainly any time markets are falling, you do start to second guess your forecast.
EQ: In a way, based on last week’s conversation, if the market does fall a little further, it could set up pretty well for the Cyclical Six strategy in terms of a bounce back.
Stovall: It does. The Technology (XLK) group has been beaten up pretty badly, and for good reason, but we think the selling has been overdone. We are sticking also with the Consumer Discretionary (XLY) overweight recommendation but are breathing a sigh of relief toward our Materials underweighting. So it does show that the global economy continues to remain on uncertain footing. While we believe the global and U.S. economies will avoid a recession, it still remains in a fragile state.
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