Though the equity bull market is still forging ahead with several more years of gains expected, every once in while we will get some pullbacks — which are quite beneficial, as they release excess steam so the boiler doesn’t explode.
Analysts are warning us to prepare now for just such a pullback, which typically strikes in the summer months. Along with those warnings come specific rotation recommendations on which stocks or sectors to exit and which to enter.
For instance, heading into the summer, the recommendation generally is to switch out of small caps and into large caps, out of energy into bond funds, and out of technology into utilities, to mention just a few examples.
But what exactly is the reason behind such rotation? Is there a general rule behind it that we can apply to our own mix of stocks to help us better decide which positions we should be trimming and which we should be enlarging?
There is such a rule, and it is based on a stock’s or ETF’s “beta.”
The Beta Measure
Simply put, “beta” gauges how volatile a stock or ETF is in relation to the broader market as a whole, using the S&P 500 index as a guide.
A stock with a beta of 1.0 is expected to move in perfect sync with the S&P 500 index. One example is the SPDR S&P 500 ETF (NYSE: SPY), which was designed specifically to track the S&P 500 index.
Stocks with a beta greater than 1.0 are more volatile than the S&P index, with the decimal amount representing the percentage of the volatility. For example, a stock with a beta of 1.1 is expected to be 110% as volatile as the S&P 500, generally rising and falling 10% more than the index does. Energy, technology, and momentum stocks generally fall into this high-beta category, as do leveraged ETFs.
For instance, a 2x S&P 500 ETF such as the ProShares Ultra S&P500 (NYSE: SSO) has a beta of 2.04, indicating that it rises and falls at twice the rate as the S&P index. (The extra 0.04 is due to the fund’s management style.)
Conversely, stocks with a beta less than 1.0 are less volatile than the S&P index, so that a stock with a beta of 0.9 is expected to be 90% as volatile as the S&P index, generally rising and falling 10% less than the index does. Bond funds and most large caps fall into this low-beta category.
There can also be negative beta readings for stocks and funds that move in the opposite direction as the S&P 500. For instance, the ProShares Short S&P 500 ETF (NYSE: SH) has a beta of -0.95. (It should be -1.0, but the fund’s management style seems to shave off a little bit of the volatility.)
To get a better sense of what beta does to a stock’s performance, let’s compare the very high beta stock Goodyear Tire (NYSE: GT), whose beta is 2.05, the PowerShares S&P 500 High Beta ETF (NYSE: SPHB) with a beta of 1.79, and the PowerShares S&P 500 Low Volatility ETF (NYSE: SPLV) with a beta of 0.51, to the S&P 500 index.
The first thing we notice is what a beta of 2 does, as Goodyear’s stock (purple) is just going bonkers as it gyrates up and down. The ETF of high beta stocks SPHB (beige) is a little tamer, while the ETF of low beta stocks SPLV (blue) is the tamest.
It is important to note that a low beta does not necessarily mean a stock will underperform the S&P 500 at all times, as the low beta SPLV is clearly beating the S&P index this year so far. All low beta means is that as the S&P broader market moves up and down, low beta stocks will move less dramatically (blue lines). In contrast, high beta stocks move more when climbing and when falling (yellow lines).
Now that we’ve outlined what the beta stat measures, how do we use it to rotate our holdings?
Using Beta as a Guide
The idea behind beta is to outperform the S&P 500 by selecting high-beta stocks when the market is bullish and low-beta stocks when the market is bearish. Running with a 1.1 beta stock during market advances will allow you to gain 10% more than the S&P gains, while switching to a beta of 0.9 when the market retreats would lose you 10% less than the broader market loses.
Simply use high beta going up and low beta coming back down. Of course, we still need to predict the right market direction up or down. But once you’ve made your best educated guess, look up your favorite stocks and ETFs for their betas and switch as required.
Note the following table of the nine SPDR Select Sector ETFs (in yellow), with a few other stocks and ETFs of varying betas as a comparison.
The smart money has already been switching according to these betas. So far this year, the best performing sector has been utilities — the lowest of the low when it comes to beta. Meanwhile, high beta sectors like energy and financials are seeing strong outflows.
“It’s a signal that investors are worried about earnings growth and U.S. economic demand, and don’t want to bet as heavily on the types of stocks that generally qualify as high beta — often cyclical names in the technology, discretionary and energy sectors,” notes Reuters.
The rotation is on. Where in 2013, the 50 highest beta stocks in the S&P 500 (gaining 51%) beat the 50 lowest beta stocks (gaining 21%), the reverse is taking place in 2014 — with the 50 lowest beta stocks (gaining 12%) beating the 50 highest beta stocks (gaining 7%).
“You see this all over the place — people are still scared,” Richard Bernstein, CEO of Richard Bernstein Advisors, explained the rotation out of higher beta into lower beta. “They’re still more worried about protecting to the downside than accentuating the upside.”
Yet the beta rule is not always cut and dry. Sometimes high trading activity can distort performance.
Expect the Odd Distortion
No matter how volatile or stable a stock is historically, its movement will periodically become distorted when investors jump in and out en masse, as they have been doing recently.
This is illustrated in the graph below comparing the currently hot low-beta utilities sector (blue), the high-beta energy sector (beige), the high-beta SPHB ETF (purple), and the low-beta SPLV ETF (orange), to the S&P 500 index (black).
The volatility of the high-beta ETF (purple) is quite understandable — but the volatility of the low beta utilities sector (blue) isn’t. While in early April the utilities did perform as a low-beta sector should, they went completely amuck in May, falling more than the high-beta ETF and much more than the S&P index. Remember, this utility sector ETF (XLU) has a beta of only 0.14. It isn’t supposed to behave this way.
What this shows is how traders can often move a stock or ETF more than its historical beta would indicate, and we must expect short-term distortions. Over longer time horizons, however, betas do perform as one would expect, with ETFs adhering more faithfully to their betas than individual stocks.
The Right Tool for the Right Job
If you are considering rotating into lower-beta sectors for the summer, don’t let their high gains of the past few months cause you to expect too much from them on the next leg up after the correction is over. While utilities have outperformed the S&P 500 by 14% to 9.5% year to date, they and other low-beta stocks will not generally beat the broader market going up. Such is not their purpose.
The real benefit to owning low-beta stocks is preservation of capital during market pullbacks, since low betas generally fall less. Once a correction has stabilized, we mustn’t stay in low-beta stocks expecting them to beat the market going up, but should switch back into higher-beta holdings when the bull run resumes.