Reversal of Fortune - Additional Research

Market Environments

As with all investment strategies, there are a variety of market environments that can impact the performance of certain stocks. An example is an environment of falling interest rates which would have a meaningful impact on the performance of banking stocks. Another would be a high inflation environment that would meaningfully impact gold and real estate stocks.

Any given market environment though does NOT explain ALL of the movement of any given securities. There are always stock and sector specific circumstances that will further influence performance. A given market environment though can often explain a lot…it’s the backdrop for individual security performance.

I’m not sure there is such a thing as a “normal” market environment but there are certainly things we can say tend to occur more often than not. One of those is that stocks that have recently performed well tend to continue to do so and vice versa. This is important to our Flex Strategy.

As discussed earlier in this blog, September 9th and 10th were days when the leaders, those stocks performing best the past 12 months, reversed course dramatically. The same was the case for the past laggards…they became the days’ winners. This is a market environment that can explain a meaningful amount of the performance of the Flex.

Details About My Research

To put the market behavior on September 9th and 10th into perspective, I did some extensive research. I focused on the 500 stocks in the S&P 500 because all of the long positions and most of the short positions are S&P 500 stocks. For every day I did the following:

I ran the above calculations for every day from July 1, 1963 to September 10, 2019.

There were two important things learned from this research. I focused on the one-day % changes of the prior 50 best performers (“Winners”) and the prior 50 worst performers (“Losers”). The difference between these two groups’ performance is very meaningful to our Flex performance as is the performance of the Winners alone. The following table shows some results from this research.

On September 5th you will see the Winners, those 50 stocks that have performed best during the prior 12 months, on average had no change while the Losers rallied an average of +3.2%. Generally speaking, this is not good for the Flex because our longs positions, represented by the Winners, produced no gains and our short positions, those represented by the Losers, rallied +3.2% causing us losses (shorts going up in price results in a loss).

Again, no market environment will explain all of the performance of a given strategy or security but it provides a backdrop that can have a meaningful impact. September 6th is an example where this research explains little or nothing as the Winners and Losers did not move much but our Flex experienced a decent gain.

As the table shows, September 9th and 10th were both very similar in nature with the prior Winners on average falling sharply on both days and the prior Losers on average rallying on both days. The difference in performance of the Winners and Losers on the 9th was -5.8% which was the biggest one-day difference since the launch of the Flex in 2010. Prior to the 9th, the biggest difference was -4.5% on November 29, 2017 which was a day the Flex lost -6.0%. Note that for the full year of 2017 the Flex produced one of its best performance since its launch…these short-term downturns very often happen in the midst of a long-term move higher.

Although September 9th was the most extreme difference in performance of the Winners and Losers since 2010, there were 67 days in our research back to 1963 when there was a more extreme difference. The biggest one-day difference was -17.0% while a total of 18 days were in double-digits. Interesting to note is that the vast majority of the biggest one-day performance differences occurred during major bear markets and sometimes just before or just after a major bear market. This is of particular note since we are not in a bear market today but we experienced a couple of back-to-back extreme one-day performance difference. I’m not exactly sure what this means but I’ll be doing more research on this.

An equally important finding from this research was the impact of the performance of the Winners alone. Let’s forget about the Losers and the difference for now and only consider the Winners. When there is a day that the Winners experience a significant average loss, our Flex Strategy is nearly certain to experience a meaningful loss. This can be explained by the fact that the Flex most often has more money invested in long positions than short positions combined with the use of leverage.

An example of the importance of the Winners’ performance is just a few months ago on June 4th. Although the difference between the Winners and Losers was -2.3% (relatively significant), the Winners were +1.2% and the Flex posted a gain. Consider that the difference of -2.3% on June 4th is not all that much different than the difference on September 5th in the above table when the Flex was meaningfully down. The difference of these two days is that the Winners were higher on June 4th, helping the Flex, while on September 5th the Winners were lower and compounded the challenges for the Flex.

Conclusion

My research clearly shows a quick flip flop of winners and losers presents a challenge for the performance of the Flex. Furthermore, a meaningful drop in just the performance of the winners is also tough. September 9th and 10th were a combination of both. The Flex performed just as would be expected in such an environment…disappointing for sure but just as expected.

The data does show these environments do not last long but they can go on for more than just 2-3 days. We can only hope this is over! Regardless, it will pass and we have every reason to believe the Flex will continue to climb higher and deliver great long-term returns.