From the MarketSci blog:
Biotech as a Leading Indicator of S&P 500 Returns
This is a follow up to CXO’s Distinctive Biotech Seasonality (h/t: The Whole Street).HT: this came in through a reader but I see that Abnormal Returns also had it.
Specifically, this a follow up to the end of CXO’s post which shows a tendency for the BTK Biotech index to lead the overall stock market by a month (i.e. positive BTK returns this month portend positive market returns next month).
[logarithmically-scaled, growth of $1, monthly-interval, frictionless]
The graph above shows the results of two strategies that go long the S&P 500 at the close on the last day of the month when BTK ended the month up either (red) or down (grey), and hold the position through the following month.
Results do not include transaction costs, slippage, or return on cash, and have not been adjusted for dividends.
On first blush it would appear that BTK has been a strong leading indicator of next month S&P 500 returns.
As a baseline, here is the same test, still trading the S&P 500, but also using the S&P 500 as the leading indicator. In other words, if the S&P 500 closes up (red) or down (grey) this month, hold the S&P 500 next month.
[logarithmically-scaled, growth of $1, monthly-interval,frictionless]
This second graph, our baseline, shows that over the last 17+ years there has also been a tendency for follow-through in the S&P 500 (i.e. up months portend stronger next-month returns than down months).
And because the S&P 500 and BTK are somewhat correlated, at least some of BTK’s prowess as a leading indicator is likely simply the result of that monthly follow-through.
But note how much smoother the equity curve is in the first graph versus the second. On the surface, it would seem that BTK is the much better predictor.
Let’s dig a little deeper (this is going to get a little wonky)…MORE
That "follow-through in the S&P 500" is the basis for trend-following, see post immediately below.
When new products come out of the fertile imaginations of Wall Street product pushers they often mark a top in that class, sector etc.
In an April 2007 post, "Indexes, ETF's and Global Warming" I said (emphasis added):
A few weeks ago Mark Gongloff had a post at the WSJ.com's EnergyRoundup with the cautionary title "Alternative Energy’s “Cover” Moment?". He ended the post with this humble line "And that could be one reason why the alternative-energy boom might continue for a while after all. Or at least, there’s a 50/50 chance of it."
Of all the "Cover Moments" the most infamous is the Aug. 13, '79 BusinessWeek "The Death of Equities" with the DJIA around 875. Paul Kedrosky has a great chart at Infectious Greed.
If you note that date, it was three years before the Big Bull started, with the Dow closing at 776.92 (I think; That day was a lifetime ago) on Aug. 12, 1982. My personal favorite cover moment was the Oct. 4 1999 BusinessWeek "The Internet Age". Both of these pale before Prof Irving Fisher's timing of his Sep. 4, 1929 statement "There may be a recession in stock prices, but not anything in the nature of a crash." (the DJIA had peaked the day before at 381, it would bottom at 41 in 1932), or his more famous Oct. '29 "...permanently high plateau".
All this history came welling up (from an admitedly strange mind) because of a line--"Cleantech: The New Biotech" that Richard Kang used a few months ago in a posting to Seeking Alpha: "Tree Huggers Unite! A Survey of Cleantech ETFs".
The Amex rolled out the BTK biotech index in October 1991 and a very astute trader told me that was a top, get flat or short of the biotechs. Good call-see chart. The biowrecks fell 50+% over the next three years....
...Is it just me or did you just hear a clang, clang, clang?
