There is one main lesson that I have learned over the past several years and that has reshaped me as an investor: before relying too much on personal convictions, I listen to the markets. I can have opinions and guide my investment decisions based on them, but it is price action and market dynamics that ultimately tell me whether I am right or wrong about my views.
Ever since the 2020 correction began to take shape, I started tracking the Invesco S&P 500 High Beta ETF (SPHB). In this article, I will explain how keeping a finger on the pulse of high beta stocks could have prevented investors from losing too much money this year – and may do so again in the future, if or when the markets undergo another correction.
(Image Credit: The Real CFO)
Why high beta matters
Before moving forward, let me talk a bit about “high beta.” Here’s a pretty simple definition from Investopedia:
Beta is a measure of a stock’s volatility in relation to the overall market. By definition, the market, such as the S&P 500 index, has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0.
Side note: I believe that there is a general misconception about what high beta investing is all about. Investopedia itself states that “high-beta stocks are supposed to be riskier but provide higher return potential.” I agree with the riskier part of the statement, but not necessarily with the higher return piece.
In my view, the key feature of high beta stocks is their more speculative nature. They are usually in pro-cyclical sectors and benefit from a strong or, even better, recovering economy. The composition of SPHB illustrates my point (see below). Two-thirds of the ETF are invested in financial services, consumer discretionary and energy stocks.
The idea is that strength in high beta stocks usually suggests optimism and risk-seeking behavior in the markets. During periods of market distress, I reason that watching ETFs like SPHB can give me a good sense of whether investors are ready to either buy stocks more aggressively or seek shelter.
The high beta test
With the above in mind, I set up a quick backtest. I calculated the trailing five-day average returns of high beta stocks since the start of 2020 and compared them to the trailing five-day average returns of the S&P 500.
- When the average return of SPHB was greater than the average return of the broad index on any given day, I would hold stocks into the next trading day, believing that a “risk-on” market dynamic was in place.
- Whenever the opposite was true, I would hold cash.
Below is how $1,000 invested according to the rules above would have performed in 2020 (blue line) compared to the S&P 500 (orange line). Notice that the timed investment would have produced substantially higher returns than the stock market, while sidestepping the large 33% decline in the first quarter. Fun fact: High beta started to show signs of market weakness in late January, and turned definitively bearish between February 21 and March 25.
(Source: D.M. Martins Research, using data from Yahoo Finance)
To be clear, I don’t necessarily believe that following the rules-based trading approach described above would work consistently to produce better returns and lower risk over longer periods of time. However, I do believe that paying attention to high beta stocks during times of distress can help to spot optimism or caution in the markets. At least so far in 2020, SPHB has done a very good job of raising the red flags before stocks fell apart and giving investors the green light once it was safe to jump back in.
The average daily return of high beta stocks flashed the “risk-off” signal 11 times over the past 12 days. Therefore, investors don’t seem very comfortable assuming larger risks at this moment. Listening to the market and paying attention to price action suggest that now may be the time to be skeptical, not overly bullish.
Beating the market by a mile
In my All-Equities Storm-Resistant Growth portfolio, I hold very few high beta stocks. Instead, I favor balance and quality, which has allowed my investment strategy to beat the S&P 500 by a mile since inception (see graph below).
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.