How I Use Industry Mean Reversion
I
am frequently asked, “Do you use anything outside of pattern
recognition and Fibonacci price and time projections in your trading?â€
My answer: “YES.”
One of those areas that
I focus on from a tree-top level are “Industry Mean Reversion Chartsâ€.
I regularly look at 20 charts of the various Industries to see where price movement
is relative to the S&P 500 (equally weighted). I’m looking to see
if they are stretched to extremes of overbought or oversold. Those areas of
overbought or oversold are measured by Standard Deviations. If an Industry Mean
Reversion chart is at —2 standard deviations, it represents an extreme
oversold condition in that particular industry. Likewise, if a chart is at +2
standard deviations, it represents an extreme overbought condition. Once I’ve
identified those industries that are at extremes I wait for my Fibonacci time
and price and pattern recognition parameters to kick in.
For
example:
Right now, the Industry
group that is at the highest extreme relative to the S&P 500 are the Consumer
Staples. They are over —2 Std devs from the mean. (I realize I’m
throwing a lot of statistical terms at you…but it’s the only way
I can say it). I drill down into stocks in that group and I’m finding
stocks that are printing Bullish patterns (i.e.,.
(
WIN |
Quote |
Chart |
News |
PowerRating),
(
BUD |
Quote |
Chart |
News |
PowerRating),
(
GIS |
Quote |
Chart |
News |
PowerRating)).
So, as these stocks
provide an entry to go long, I take it. I’ve obviously simplified it,
but it gives you a snapshot of one way that I look at the market.
Let me give you a summary
of the various sectors and approximately where they stand (as of 10/24/03):
Energy: -1.0 Std dev
Materials: -1.0 Std dev
Capital Goods: At The Mean
Commercial Services & Supplies: -1.0 Std dev
Transportation: At The Mean
Consumer Durables & Apparel: -0.5 Std dev
Hotel Restaurants & Leisure: -0.5 Std dev
Media: -1.0 Std dev
Retailing: -0.3 Std dev
Consumer Staples: -2.3 Std dev
Health Care Equip & Services: -1.0 Std dev
Pharma & Biotechnology: -0.3 Std dev
Banks: -1.0 Std dev
Diversified Financials: -0.1 Std dev
Insurance: -1.5 Std dev
REITS: -0.5 Std dev
Software & Services: +0.3 Std dev
Technology Hardware & Equip: +1.0 Std dev
Telecommunications Services: At The Mean
Utilities: +0.5 Std dev
So what does this data tell me? I have a few observations:
1. I think it is very interesting
that although I “feel†like the market is very extended, the various
industries groups are NOT, and do not reflect that relative to the movement
of the S&P 500. If anything as a whole I look at these industries and chalk
this data into the bullish column.
2. If money continues to stay in the market, there is a very good chance that
we see money flow from Tech oriented stocks to Consumer Staples and Insurance
where there are extreme downside conditions and a good chance for “reversion
to the mean†and those beaten down industries could see price appreciation
simply on this statistical fact.
3. I find it very interesting that Outside of technology most industry groups
are actually in the “red†or negative price movement as an industry
relative to the S&P. That also tells me a couple of things:
a. We either have a hollow rally that is being fueled by capital goods and technology
and once that party is over, the markets collapse and capital again floats into
alternative investments (bonds, commodities, international, etc).
b. Or….due to the lack of more attractive investment choices, money simply
flows from the current hot industry groups into all of these other groups that
are in no way extended and it allows this market to continue to climb upward.
c. Or….I have no clue what I’m talking about. Which is always a
real option as a trader.
I think it is critical that
traders have a way to look at the market from the bigger picture before drilling
down into the micro trading plan. This is one way to do it. I’m sure people
will ask where I get these charts. Our office accesses this data through Ned
Davis Research.
Now that I’ve required
you to dust off those statistics books…have a great (mean-reverting) evening!
derrik@fibzone.com