Tuesday, May 10, 2005 1:41:28 AM
John Murphy’s Misinterpretation of XLV:$SPX Ratio
This afternoon, I posted this question on my favorite Seasonality board http://www.investorshub.com/boards/read_msg.asp?message_id=6286409
John Murphy used this chart and the excerpted message after the chart to make a case for XLV as a counter trend play against the possible down market.
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Beginning of excerpt --- “(This Chart) puts that upturn into better perspective and helps us to draw some conclusions about the defensive qualities of healthcare. The weekly bars show the bull market in the S&P that started in October 2002. The green line is the relative strength ratio of the Healthcare SPDR (XLV) divided by the S&P. Notice their inverse correlation. The upturn in the S&P in the first quarter of 2003 started a two-year period of underperformance by healthcare. That's perfectly consistent with the tendency for defensive groups to underperform when the market is rising. A rising market favors offensive stock groups (like technology) and ignores defensive groups (like healthcare). To the bottom right of Chart 3, however, the ratio has broken its two-year down trendline. That tells us two things. The market has turned defensive. And healthcare stocks are back in favor. Let's go back even further in time. --- end of excerpt.
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I provided these 3 charts to show just how this ratio comparison was skewed. The first chart shows the use of the same ratio made this small 23-people operation of a commercial leasing service, Gladstone Commercial Corp. (GOOD), looked like a pretty good ”defensive” play too. BTW, GOOD had just IPO’d less than 2 years ago. So, please don’t even think about it as a defensive play whatsoever.
The Cisco to S&P Ratio sure made Cisco looked like having a pretty good inverse correlation with S&P as well.
And, of course US Dollar’s also looking good.
When we divide a stock by another stock, the quotient is the ratio of these 2 stocks. The only time this quotient will ever change is when either the dividend (XLV) or the divisor (S&P) changes. One simplistic way is to look at this as an exchange rate between the XLV and the S&P currencies.
The dynamics of this equation creates a divergence between the 2 by default. Comparing the quotient of this division against the divisor has the propensity to breed inverse correlation. This inverse correlation is therefore skewed.
The only way for this to project an accurate inverse correlation is to trade the derivative the equivalence of this quotient and NOT the equity XLV itself. And, due to the small value of this quotient (this XLV to S&P ratio is only about 0.0274), I’m not sure if it’s physically possible to set up such spread in actual trading.
I admire John Murphy’s accomplishment, and I’ve learned a lot from reading his technical text books. But, this one needs to be re-worked. I’m sorry.
The bottom line is that the Healthcare sector, or the XLV, does NOT have a consistent inverse correlation with the S&P.
This afternoon, I posted this question on my favorite Seasonality board http://www.investorshub.com/boards/read_msg.asp?message_id=6286409
John Murphy used this chart and the excerpted message after the chart to make a case for XLV as a counter trend play against the possible down market.
-------
Beginning of excerpt --- “(This Chart) puts that upturn into better perspective and helps us to draw some conclusions about the defensive qualities of healthcare. The weekly bars show the bull market in the S&P that started in October 2002. The green line is the relative strength ratio of the Healthcare SPDR (XLV) divided by the S&P. Notice their inverse correlation. The upturn in the S&P in the first quarter of 2003 started a two-year period of underperformance by healthcare. That's perfectly consistent with the tendency for defensive groups to underperform when the market is rising. A rising market favors offensive stock groups (like technology) and ignores defensive groups (like healthcare). To the bottom right of Chart 3, however, the ratio has broken its two-year down trendline. That tells us two things. The market has turned defensive. And healthcare stocks are back in favor. Let's go back even further in time. --- end of excerpt.
------------
I provided these 3 charts to show just how this ratio comparison was skewed. The first chart shows the use of the same ratio made this small 23-people operation of a commercial leasing service, Gladstone Commercial Corp. (GOOD), looked like a pretty good ”defensive” play too. BTW, GOOD had just IPO’d less than 2 years ago. So, please don’t even think about it as a defensive play whatsoever.
The Cisco to S&P Ratio sure made Cisco looked like having a pretty good inverse correlation with S&P as well.
And, of course US Dollar’s also looking good.
When we divide a stock by another stock, the quotient is the ratio of these 2 stocks. The only time this quotient will ever change is when either the dividend (XLV) or the divisor (S&P) changes. One simplistic way is to look at this as an exchange rate between the XLV and the S&P currencies.
The dynamics of this equation creates a divergence between the 2 by default. Comparing the quotient of this division against the divisor has the propensity to breed inverse correlation. This inverse correlation is therefore skewed.
The only way for this to project an accurate inverse correlation is to trade the derivative the equivalence of this quotient and NOT the equity XLV itself. And, due to the small value of this quotient (this XLV to S&P ratio is only about 0.0274), I’m not sure if it’s physically possible to set up such spread in actual trading.
I admire John Murphy’s accomplishment, and I’ve learned a lot from reading his technical text books. But, this one needs to be re-worked. I’m sorry.
The bottom line is that the Healthcare sector, or the XLV, does NOT have a consistent inverse correlation with the S&P.
David
#board-3693
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