In March of 2018 we at Financial Sense® Wealth Management conducted a study (see Does Mean Reversion Always Hold True?) testing the long-held trading strategy of “mean reversion” across the 9 major S&P sectors. Think of “mean reversion” like a rubber band between your fingers that reverts or snaps back to an equilibrium state after stretching it in one direction. As a trading strategy, such extremes in the markets can potentially signal significant turning points or reversals of trends and provide advantageous investment opportunities.
Looking back at the past 30 years, we analyzed the forward returns of all 9 S&P industry sectors when their relative under-performance to the S&P 500 reached statistical extremes (-2 and -3 standard deviations). In other words, we tested if S&P sectors revert to the mean (snap back) when they are significantly underperforming the market and stretched to the downside.
Our results intrigued us. Below is a summary of our key findings from 2018:
- Only a select number of sectors have historically outperformed the S&P (reverted to the mean) when already underperforming (by at least -2 standard deviations): Top 3 being Consumer Discretionary, Industrials and Healthcare.
- The same sectors that historically have outperformed the S&P after significantly underperforming (Industrials, Consumer Discretionary, Healthcare) have repeatedly done so a high percentage of the time.
- When extremely underperforming the market by at least -3 standard deviations, the following sectors most consistently outperformed the S&P within a 12-month time frame: Top 3 being Technology, Utilities and Consumer Discretionary.
- There are sectors that, on average, do not revert to their mean regardless of their underperformance: Financials, Consumer Staples and Energy. In other words, these sectors that have significantly underperformed the market have historically continued to do so for at least 12-months.
This study has provided us timely insights when analyzing sector rotation as well as a tool to use when developing investment ideas to help generate alpha.
After many months, we decided to revisit this study but with a different spin – we wondered, do S&P sectors revert to the mean when they have significantly outperformed the market?
Going back to 1989, we looked at the 4 ranges of forward-looking relative performance (1 month, 3 month, 6 month and 1 year) of each of the 9 S&P sectors versus the S&P index including: Industrials, Financials, Energy, Information Technology, Consumer Discretionary, Materials, Consumer Staples, Healthcare and Utilities.
We then used the relative performance of each sector to find the z-score or the number of standard deviations of each sector’s relative performance from its historical average.
For those who need a brief refresher in statistics – in both studies, we looked at events that took place in the outer tails of a normal distribution curve – events that historically have happened 2.35% to 0.15% of the time (2 and 3 standard deviations respectively).
After, we grouped occurrences where there was a positive 2 standard deviation outperformance or greater of the sector relative to the S&P 500 and then found the corresponding 1-month, 3-month, 6-month and 12-month forward relative performance to determine whether mean reversion occurred and resulted in underperformance.
1. Only select sectors historically have reverted to their mean when they have outperformed the S&P 500 by 2 standard deviations or greater.
In context of mean reversion, we would expect sectors that have outperformed the market by a significant measure to pullback and underperform as excess is removed from the market and prices normalize. However, according to our data, only a few select sectors (Utilities, Healthcare and Materials) seem to exhibit mean reversion when they have outperformed the broader market by 2 standard deviations or greater. This can clearly be seen in the bottom ranges (orange and red) in the chart below.
Incidentally, the same sectors that display the poorest risk-adjusted forward returns in the table above also tended to historically underperform most consistently over the past 30 years. As shown in the graphic below, Utilities, Industrials, Healthcare, and Materials tend to mean revert when significantly overbought.
As an example, the Utilities sector historically exhibits strong mean reversion after significantly outperforming the overall market. Its underperformance can begin as quickly as the first month after it has reached a 2 standard deviation outperformance of the market. As you can see in the table above, Utilities underperformed 67% of the time just 1 month after their outperformance.
For another example, consider the S&P Industrial sector. Industrials outperformed the S&P by 3 standard deviations when the trend reversed in early January 2018. As shown below, what followed was a 12-month reversion where Industrials underperformed the S&P index by almost 9%. Although this was one of the worst cases of its mean reversion in a 12-month time frame, Industrials historically underperformed as a sector over 61% of the time once hitting extreme relative outperformance levels.
2. There are select sectors that historically continue to outperform even when they are overbought on a relative basis.
According to our data, Financials, Information Technology and Consumer Discretionary sectors didn't tend to revert to their mean when overbought but instead continued to outperform the market within a 12-month time frame. This supports our idea that mean reversion doesn’t hold true for momentum-type stocks. In other words, investors have historically been rewarded when investing in sectors like Financials, Tech and Consumer Discretionary even when they have already outperformed the S&P by at least 2 standard deviations. Further, an investor’s risk-adjusted performance is significantly greater after a 6-month period, which means that momentum-type sectors aren’t resistant to short-term pullbacks during a one to three-month period even when overbought.
According to our data, these same sectors have a good track record of outperforming the S&P when significantly overbought on a relative basis.
3. Specific sectors exhibit unique mean reversion characteristics that are useful when looking for investment opportunities.
The difference between Healthcare’s 6-month and 1-year respective hit rates and average returns illustrate the sector's unique mean reversion characteristics.
The Healthcare sector tends to show relatively strong mean reversion to the downside within a 6-month time frame. However, within 6-12 months, the sector tends to experience extremely strong rebounds in relative performance. This is likely because within a 6-12 month time frame, the sector has significantly underperformed the S&P 500 and is due for mean reversion in the opposite direction. This is exactly what would be expected from the sector based on our previous study Does Mean Reversion Always Hold True?.
Another sector that displays unique attributes is the Consumer Staples sector. Consumer Staples doesn't offer any identifiable mean reversion characteristics once it has outperformed or underperformed the S&P 500 by 2 standard deviations. This is shown again in our previous article where we state: “Looking at Consumer Staples, the sector’s forward returns seem to have little to do with their over or underperformance to the market. This could likely be explained given the fact that this sector generally offers steady dividends, strong financials, and is less volatile relative to the rest of the market.”
Lastly, we would like to point out and emphasize the lack of mean reversion in the Technology sector. Tech has been a leader in momentum throughout this current bull market.
The chart above illustrates the 252-day average z-score of the relative performance between technology, using the SPDR Technology ETF (XLK), and the S&P 500 Index. Over the past 10 years, the Technology sector has outperformed the market (stayed above the red dashed line) for a large percentage of the time. The sector has experienced pullbacks (dips from the top green line down to below the red dashed line) due to its “overbought” nature, but these pullbacks have proven to be short lived. In other words, over the past 10 years, investors have been rewarded to not rotate out of technology even when the industry is already outperforming.
Each sector should be considered on their own when discussing mean reversion. This leads us to a similar conclusion that we made at the end of 2018 – not all sectors are created equal. However you slice it, mean reversion must be examined within the context of each sector respectively. We believe this article and our last, Does Mean Reversion Always Hold True?, offers investors valuable insight into sector mean reversion and a better understanding as to how sector rotation can be observed.
Financial Sense Advisors, DBA Financial Sense Wealth Management, is a Registered Investment Advisory firm providing services in the areas of Wealth Management, Financial Planning, Retirement Services, Insurance and many others. If you would like to speak with one of our licensed Wealth Managers, please give us a call at (858) 487-3939, or Contact Us.
Disclosures: All data has been provided by Bloomberg. This information is for educational purposes only and is not intended to be investment advice. The information provides here does not consider reader’s suitability or risk tolerance. Be advised that you invest at your own risk. For your particular financial management needs and situation, please consult your financial advisor.