Market Neutral Strategy May Be Perfect for the Current Market

Rick_PendergraftOver the last few months I have written about sector rotation and where we are in the economic cycle. The combination of what I have already written and some research and analysis I was working on regarding hedge funds, led me to dig into the sentiment of each of the ten main sectors. A couple of years ago I developed a sentiment composite indicator for individual stocks that looked at the short interest ratio, the put/call ratio and the analyst ratings and combined them in to one number.

The research and analysis I was doing toward hedge funds had me thinking about a specific type of hedge fund strategy known as an equity long/short strategy. Essentially what the fund does is buy one stock in a sector and short another stock within the same sector. The idea is that if the market moves higher, the stock held long will rise more than the stock they sold short, as long as their research is good. If the market moves down, the stock they sold will decline more than the one they bought. The strategy is a market neutral strategy and ideally makes money in an up or down market.

With this in mind, I took the ten Select Sector Spyders and looked at the top ten holdings within each of the ETFs and compiled sentiment composite readings for each of the ten stocks in the ETF. The foundation for this process came about as a result of looking at a table I compiled back in May for the semiconductor sector.

Here is the table that was created on May 14.


With the long/short strategy in mind, I looked at what would have happened from May until now and if one had purchased the two stocks with the highest sentiment composite readings and sold the stocks with the smallest readings. The following chart shows how the stocks performed.


As you can see, going long Intel and Taiwan Semiconductor would have proven profitable thanks to Intel’s gain. On the other side, shorting Xilinx and ARM Holdings proved to be a breakeven strategy with XLNX losing and ARMH gaining. It should be noted that the S&P was up 7.9% during this same time frame.

After seeing those results, I decided I wanted to track the sector ETFs going forward to see if I would get similar results. Once I had the results for each sector, I decided to compare sectors and the average composite readings. Right now, the Consumer Discretionary Sector is the most loved by investors and analyst and Telecom is the most hated. The table below shows all the results.


With the market momentum so heavily skewed toward the bullish camp, it is hard to have an all out bearish stance. With the market so overbought, it is hard to have an all out bullish stance. Perhaps now is the perfect time for a market neutral strategy. And the sentiment tools might be the perfect indicators for deciding what to buy and what to sell short.

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