Taken in isolation the absolute return differential does not seem significant. However, by normalizing each sector’s return by its volatility, we can create a risk-adjusted return dispersion index for the eleven S&P 500 sectors. Figure 3 shows this index rolling through time, and we can see the current level is significantly above average, measured since January 1st, 2000. At its current level, sector dispersion will continue to be a metric that we closely monitor to inform our investment decisions.
Heading into May, we have a more neutral view about the opportunities within the domestic equity market. The abnormally low level of market implied volatility as measured by the CBOE VIX index, and the fact that volatility tends to revert to the mean, gives us some pause.
The aforementioned absolute return dispersion in S&P 500 sector returns provides some insight into a more appropriate level of volatility. The scatter plot shown in Figure 4 displays the relationship between the CBOE VIX index and the S&P 500 sector absolute return differential. Based solely on this relationship, at these levels of return dispersion we would expect a higher level of market volatility.
Summary
U.S. equity markets concluded the first four months of 2017 exhibiting strong performance; however, the momentum started to wane by the beginning of March. Markets remain concerned about the likelihood of increased growth due to U.S. fiscal policy changes. Market sentiment, based primarily on investor surveys, remains elevated relative to the past ten years while actual measurements of economic growth – auto sales, retail sales, GDP – have not yet increased.
This divergence between the sentiment data and economic growth data and the wide scope of potential outcomes for U.S. fiscal policy has created significantly large return dispersion within U.S. sectors. Comparing the S&P 500 sector return dispersion to the CBOE VIX index, the CBOE VIX index appears to be low. It is the confluence of these factors – increasing political uncertainty, large divergence between macroeconomic sentiment and macroeconomic growth, abnormally low market implied volatility, and increased S&P 500 sector return dispersion – that leaves us with a more cautionary, neutral stance towards U.S. equity markets.
This article was written by Innealta Capital, a participant in the ETF Strategist Channel.
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The information provided comes from independent sources believed reliable, but accuracy is not guaranteed and has not been independently verified. The security information, portfolio management and tactical decision process are opinions of Innealta Capital (Innealta), and the performance results of such recommendations are subject to risks and uncertainties. Past performance is not a guarantee of future results. Any investment is subject to risk. Exchange traded funds (ETFs) are subject to risks similar to those of stocks, such as market risk, and investors that have their funds invested in accordance with the portfolios may experience losses. Additionally, fixed income (bond) ETFs are subject to interest rate risk which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. The value of an investment and the return on invested capital will fluctuate over time and, when sold or redeemed, may be worth less than its original cost. This material is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a solicitation or an offer, or a recommendation, to buy a security. Investors should consult with an investment advisor to determine the appropriate investment vehicle. Investment decisions should be made based on the investor’s specific financial needs and objectives, goals, time horizon and risk tolerance. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Chart Definitions Consumer Confidence refers to the Consumer Board Consumer Confidence Index. Technology refers to The S&P 500 Information Technology Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS information technology sector. Consumer Discretionary refers to The S&P 500 Consumer Discretionary Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS consumer discretionary sector. Healthcare refers to The S&P 500 Health Care Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS health care sector. Consumer Staples refers to The S&P 500 Consumer Staples Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS consumer staples sector. Materials refers to The S&P 500 Materials Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS materials sector. Utilities refers to The S&P 500 Utilities Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS utilities sector. S&P 500 refers to the S&P 500 Index (Large Cap Equity), which measures the performance of the large capitalization sector of the U.S. equity market and is considered one of the best representations of the domestic economy. Industrials refers to The S&P 500 Industrials Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS industrials sector. Real Estate refers to The S&P 500 Real Estate Index, which comprises stocks included in the S&P 500 that are classified as members of the GICS real estate sector. Financials refers to The S&P 500 Financials Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS financials sector. Telecom refers to The S&P 500 Telecommunication Services Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS telecommunication servicessector. Energy refers to The S&P 500 Energy Index, which comprises those companies included in the S&P 500 that are classified as members of the GICS energy sector. VIX refers to the CBOE Volatility Index® (VIX® Index®), which is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Sector Dispersion Index is the It is not possible to invest directly in an index. AFAM Capital, Inc. is a registered investment adviser. Al Frank Asset Management and Innealta Capital are divisions of AFAM Capital. AFAM is the investment advisor to individually managed client accounts and certain mutual funds. For more information, please visit afamcapital.com. Registration as an investment advisor does not imply any certain level of skill or training. Innealta is an asset manager specializing in the active management of portfolios of ETFs. Contact your financial advisor for additional information. 182-AFAM-5/15/2017