Industrials Vs. Health Care Sectors

I came upon an interesting article which studied the long term trends between the Industrial and Health Care sectors.  It used the ratio of the Industrial Select Sector ETF (XLI) to the Health Care Select Sector (XLV).  The chart in the post shows the entire life of the ETFs and goes back to 1998.  I’ve recreated a portion of it here:

That is quite a dip in the ratio over the past 12 months.  That represents a significant outperformance on the part of the Health Care stocks.  However, the article points out that the President’s political agenda seems to have two significant points:

1. Invest in infrastructure
2. Reform health care

Now as for the first, I’ll believe it when I see it because the stimulus bill was a little disappointing on the infrastructure - and therefore the industrial - front.  Health care reform does appear to be a more realistic goal.  We will have to see.

Those are fundamental reasons - which frankly border on ‘trading the news’ - but what do the charts tell us?

Reversion to the mean can be a powerful force.  In the case of the XLI:XLV ratio, the 130 week exponential moving average is discussed in the article as being an important support and resistance level.  Should the ratio begin to work up towards the 130 wk EMA, that would represent strong outperformance in the XLI.

The article points out that tradeable turning points occur when the stochastics reached extreme levels - they were overbought in mid 2008 and the ratio plummeted.  The chart in the article shows oversold conditions that led to an industrial rally.  Could we be ready for a sector rotation?  The industrials could in theory have a long way to rally relative to the health care sector in order to revert to the mean.

So what is the trade in that situation?  The easy answer is that you go long the outperformer and short the underperformer.  It is a hedge - in theory neither moves too far in one direction for too long relative to the overall market.  However, you must remove your bullish bias in this situation.  In a bull market your long position will make more money than your short position will lose you.  In a bear market your short position will make you more than your long position will lose you.  Know where your money will be made.

Here is an example of a hypothetical trade based on the May 2008 turn in the stochastics to current day - a trade would have made you $290 on a $2000 investment.  14.5% would have made you a superstar compared to the losses in the overall market.

Would a straight short have done better?  Sure, but in a certain world we all know what to trade - when dealing with uncertainty, it’s important to have a smart hedging strategy such as this.

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