Trading Strategies: Semiconductors Lead the Stock Market

By Michael Stokes | August 21, 2008 | 10:37 AM | 1 Comment

This trading strategy was inspired by a couple of recent posts from Rob Hanna's Quantifiable Edges. Rob's basic idea is that when the semiconductor sector (^SOXX) takes a leadership role in the market, other stocks tend to follow, portending strong returns in the near future.

I'm going to expand on Rob's idea and share an embarrassingly simple trading strategy with a lot more exposure to the market that is maybe more suitable as a core portfolio strategy.

The strategy: go long the S&P 500 at today's close if the SOXX increases more today (in % terms) than the S&P 500. Close the position at today's close when it increases less. I told you it was embarrassingly simple. This is just a proof-of-concept, so I'll assume a frictionless market (no transaction costs, no return on cash, etc.)

The graph above shows the S&P 500 index (blue), the strategy (green), and what happened in the market when the strategy was in cash (red) from mid-1994 to date. Stats below.

 

That's a sharp contrast. When the SOXX outperformed the broader market, the stock market performed considerably better the next day.

Three comments about the results above:

First, a look at the graph shows that this strategy underperformed up trending markets, but it also did a VERY good job at protecting against all of the major bear markets of the last 14+ years; and I think that's the idea's greatest strength.

Second, this strategy only spent about half of all days in the market. I think there is a lot of value in staying out of the market as much as possible IF you can still accomplish your trading goals. It frees up capital for seeking out other opportunities and reduces the risk of getting caught looking the wrong way in a catastrophic fat-tail day (a'la Oct. of 1987).

And lastly, bear in mind that this test was frictionless - real world considerations could reduce the returns here. But I think that we clearly proved that Rob's idea has a lot of merit. Would I take a position solely based on SOXX leadership? No. Would I use it as one of many considerations for taking a position? Absolutely.

Happy Trading,

 

MarketSci Blog

An Alternative Idea Michael: Several years ago I did a study where asked the question: what happened to stocks after the Semiconductors made a new 13 week high. The results were somewhat dissappointing. The premise behind this study was that as the market moved higher, investors would pile into stocks, particularly semiconductors, to achieve greater gains. What I found was that more often new 13 week highs in SMH also meant highs for stocks in general. The "breakout" really was a fakeout. What I have found with backtesting is that the results really depends upon one's time frame and risk tolerance. In this case, your study was helpful because such a strategy helped avoid bad markets. If we just tweak the inputs, I can get different results, which might help me manage my expectations. Submitted by Guy Lerner on Thu, 2008/08/21 - 11:15am » reply |