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Sector Breadth as Market Return Indicator

| | Posted in: Momentum Investing, Technical Trading

Does breadth of equity sector performance predict overall stock market return? To investigate, we relate next-month stock market return to sector breadth (number of sectors with positive past returns) over lookback intervals ranging from 1 to 12 months. We consider the following nine sector exchange-traded funds (ETF) offered as Standard & Poor’s Depository Receipts (SPDR):

Materials Select Sector SPDR (XLB)
Energy Select Sector SPDR (XLE)
Financial Select Sector SPDR (XLF)
Industrial Select Sector SPDR (XLI)
Technology Select Sector SPDR (XLK)
Consumer Staples Select Sector SPDR (XLP)
Utilities Select Sector SPDR (XLU)
Health Care Select Sector SPDR (XLV)
Consumer Discretionary Select SPDR (XLY)

We use SPDR S&P 500 (SPY) to represent the overall stock market. Using monthly dividend-adjusted returns for SPY and the sector ETFs during December 1998 through September 2020, we find that:

To accommodate the longest lookback interval, relationship calculations commence at the end of December 1999.

First, we look at correlations between sector breadth and next-month SPY return across lookback intervals. For comparison, we include correlations between next-month SPY return and sign of SPY past return over the same intervals. Notable points are:

  • Nearly all correlations are positive, but all are small in magnitude.
  • For relatively short (long) lookback intervals, market breadth (sign of past SPY return) has the stronger linear relationship with next-month SPY return.

For another perspective, we calculate average next-month SPY returns for all combinations of sector breadth and lookback interval.

The following chart summarizes average next-month SPY total returns by number of sectors with positive past returns (breadth 0 to 9 on the horizontal axis) and by lookback interval (chart legend, in months). For reference, it also shows average next-month SPY return when past SPY return is positive for each lookback interval (intrinsic or absolute or time series momentum for SPY). The red horizontal line indicates average monthly SPY total return for all months in the sample period (0.58%). Notable points are:

  • Interactions between sector breadth and next-month SPY returns are mostly erratic across lookback intervals for breadths of 7 sectors or less. Results for breadth 2 are anomalously strong on average across lookbacks.
  • Breadths of 8 (9) sectors indicate above average next-month SPY returns across 10 of 12 (12 of 12) lookback intervals, with 1-month (3-month) lookback optimal. However:
    • For the 1-month lookback interval, breadth is 8 for only 29 months (12% of the sample).
    • For the 3-month lookback interval, breadth is 9 for only 55 months (22% of the sample).
    • The outperformance of strong sector breadth compared to simple SPY intrinsic momentum is modest, and intrinsic momentum is in the market far more often.

It appears unlikely that there is any straightforward way to exploit findings and beat buying and holding SPY at a portfolio level.

The following table provides detailed inputs for the previous chart, highlighting combinations of sector breadth the highest (orange shading) and lowest (blue shading) average next-month SPY returns for each lookback interval and for the average across all lookback intervals.

In summary, evidence indicates that strong equity sector breadth predicts higher-than-average next-month stock market returns, but such breadth appears difficult to exploit due to rarity.

Cautions regarding findings include:

  • The sample period is not long with respect to the longest sector momentum lookback interval.
  • Testing many strategy variations introduces data snooping bias, such that the best-performing variation overstates expectations.
  • Results are in-sample. An investor operating in real time may have had difficulty discerning them for much of the sample period.
  • As noted, at the portfolio level (with cash in reserve for responses to signals), the findings may not be useful. SPY intrinsic momentum is more easily exploited.
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