Sector Neutral Sub-Industry (L-4) Pair Trade Ideas

Intro

We have been communicating to clients that our work sees the market slowly moving towards an idiosyncratic/stock picking environment. This report will identify sector neutral sub-industry pairs.  These can used for either over/underweight by traditional long only investors or as long/short pairs by traders. 

In deriving these pairs, we will be using the following proprietary analytical tools:

• 8-panels/ASM

• HALO

If you are also interested in which single stock names look interesting for these pairs, please reach out and we will make them available. 

(See appendix for description of 8-panels and HALO)

Macro Update

• Tactical indicators suggest rising probability that trading bounce could reach 4100-4200…

• …but, macro view and earnings revision work point to the rally being of short duration, smallish magnitude, and likely to fail.  Sell into it and increase hedges. 

• Fed hawkishness is real.  Do not underestimate their resolve in the tightening cycle.

• Economic slowdown fears and negative estimates will likely begin to increase.

Sub-Industry Pair Ideas

• Industrials (L-1)

Industrial Machinery vs. Human Resources (L-4)

• Consumer Discretionary (L-1)

Auto Parts vs. Department Stores (L-4)

• Staples (L-1)

Soft Drinks vs. Hypermarkets (L-4)

• Financials (L-1)

Investment Banks vs. Regional Banks (L-4)

Sector Recommendations

You may be asking yourself what is with the fancy title “Sector Neutral Sub-Industry (L-4)” pair trades?  Well, this is some of the vocabulary that I regularly use with my institutional clients.  So, I thought I would include some brief comments to put this note in context for you and to bring you into the professional investor realm (if you are already a pro, maybe I can still try to enlighten you somewhat).

First, an explanation of some terminology:

Sector (GICS L-1) and Sub-Industry (GICS L-4) — The S&P 1500 constituents are classified into four different buckets that go from high level to quite granular, and this is part of the Global Industry Classification System (see HERE for more detailed description) as created by S&P Global. 

• Sectors GICS L-1 (11 Sectors)
• Industry Groups GICS L-2 (24 Industry Groups)
• Industries GICS L-3 (69 Industries)
• Sub-Industries GICS L-4 (158 Sub-Industries)

Pair trade — This is a broad and general term when a professional investor expects one idea to do better than another, and “pair” them by going long/overweight one and short/underweight the other. 

Sector neutral — This is a specific type of pair trade when an investor has zero exposure (i.e., neutral) at the sector level (GICS L-1). This is achieved by going long/overweight one sub-industry (GICS L-4) stock while at the same to going short/underweight a different sub-industry (GICS L-4) all within the same sector. 

How could a retail investor use this type of recommendation?  If you are one who actively manages his/her portfolio by investing in either ETFs or single stocks, the favored area is one that is supported by my key indicators, while the unfavored area looks less appealing.  Thus, if you have a diversified portfolio with exposure to all parts of the equity market, looking for new ideas in the long/overweight bucket should outperform the ideas in the short/underweight part of the pair trade. 

I hope this brief explanation helps demystify things a bit and please be on the lookout for more detailed educational notes going forward. Always remember we have a dedicated team to answer your questions an e-mail away at inquiry@fsinsight.com. If you are still a bit confused, that is OK.  Becoming a better investor is a marathon, not a sprint. This takes time, effort, patience, and discipline. So, stick with it, and we will have an interesting and informative journey together over time. 

GICS L-1 Sector:Industrials

GICS L-4 Sub-Industry Pair:

Industrial Machinery vs. Human Resources

S&P 1500 Constituents

GICS L-1 Sector:Cons. Discretionary

GICS L-4 Sub-Industry Pair:

Auto Parts vs. Department Stores

S&P 1500 Constituents

GICS L-1 Sector:Staples

GICS L-4 Sub-Industry Pair:

Soft Drinks vs. Hypermarkets

S&P 1500 Constituents

GICS L-1 Sector: Financials

GICS L-4 Sub-Industry Pair:

Diversified Capital & Brokerage vs. Regional Banks

S&P 1500 Constituents

Appendix: 8-Panel Analysis Intro

8-Panel Analysis – Methodology

Our proprietary 8-panel analysis is a key piece of information for new idea generation in our investment recommendation process. It provides a subjective, but disciplined, assessment of reward and risk by examining earnings estimate revisions, valuation, and price reversion for sectors (GICS L-1), industries (GICS L-3), and sub-industries (GICS L-4) versus the market or peers to predict 9-18 month relative performance.

The main inputs of an 8-panel chart page are as follows (see next page for example):

► Analyst Sentiment Measure (ASM)*: Our ASM indicator is a proprietary measure of relative earnings estimate revisions at the sector/sub-industry levels and is the most important input for the majority of our investment recommendations. It is both a momentum and contrarian tool depending on its level relative to the previous two decades. We will typically conclude that the investment trend for a recommendation is consistent with the slope of this historical time series, and that the maximum risk/reward opportunity occurs near the inflection point of an extreme reading.

Our analysis has found that the critical strategic factor to determine the dominant relative performance trend for most S&P GICS groupings is the aggregation of analyst behavior at the company level regarding their forward profit expectations. When the ASM is combined with extreme readings of several other 8-panel inputs, our research shows that the ASM has been a powerful leading relative performance indicator (“clustering” – see pages 12 and 13 for examples). 

► Valuation: We view valuation as a measure of potential risk, and its importance comes from its current reading compared with levels at major historical relative performance inflections.

► Price Reversion Oscillators (PRO): Based on our analysis, the synthesis of three distinct time-duration price oscillators (short, medium, and long term) is an invaluable analytical technique for measuring price reversion. We utilize different increments of time for our standard strategic ideas (13wk, 26wk, 52wk) versus tactical ideas (2wk, 4wk, 8wk), but the concept is the same as we are looking for confirming overbought/oversold readings on all three metrics at the same time.

*  At its core, our ASM indicator is built upon a publicly available formula — (Up Estimates – Down Estimates) / (Total Estimates) — that has been around for decades. We do not know its original derivation, but the earliest citing we can find is The Journal of Investing, “Earnings Revisions and Portfolio Returns”, Fall 2001.

Sources:  Fundstrat Global Advisors and Factset

8-Panel Analysis – A Powerful, Proprietary Tool For Idea Selection (Example only – Data not Live)

8-Panel Analysis – How To Use

• We first begin with the Analyst Sentiment Measure (ASM) chart (top chart shown below) as our analysis finds that nearly every group in the market trades with a natural profit cycle that is the primary driver of relative performance.

• Our most-actionable, highest-conviction ideas occur when the ASM inflects from an extreme level. Specifically, the best long ideas occur when the ASM rolls up from a negative extreme (point A below), which our work suggests is at/near maximum entry point and when risk/reward is most favorable, while the best exit point is when the ASM rolls down from a positive level (point B).

• As a reminder, a positive inflection reflects fewer analysts cutting forward estimates, and NOT analysts raising, and a negative inflection is when fewer analysts are raising. Our work suggests the bad or good news, respectively, is fully priced in at these points.

• When our ASM is clearly trending in one direction (green and red arrows), the model is in a momentum phase and the group’s relative performance is likely to mirror the slope of our ASM.

• When evaluating an ASM inflection for new money, we add two valuation metrics to our analysis to further consider the group’s relative favorability versus history and the market, with extreme valuation at an inflection point supporting a change in relative performance trend.

• Once we have determined that a particular group looks favorable or unfavorable from an earnings revision basis, we then turn to our Price Reversion Oscillator (PRO) charts below to help with implementation timing.

• We find that every group in the market trades with a  natural rhythm, outperforming and underperforming by specific amounts over various time frames (we show 13, 26, and 52 weeks), and that this pattern is quite predictable and exploitable.

• When our price oscillators are at the low end of their oscillation range (i.e. oversold), our work suggests this presents a favorable entry point for new money. Conversely, exiting an overbought group while the ASM is inflecting lower captures the highest gains.

• Our highest-conviction, most-probable new money ideas occur when the stock is oversold at the time the ASM rolls up. When the ASM is positively sloped but a group is overbought, the ASM remains the dominant trend, but the magnitude of outperformance may be limited as the overbought condition is reversed.

• A group that is long-term oversold but short-term overbought may simply need time to digest gains before making another leg higher.

8-Panel Analysis – Buy Signal Clustering

8-Panel Analysis – Sell Signal Clustering

Tactical Model (“HALO”) – Intro

The Fundstrat Global Portfolio Strategy Team has also developed a short-term model that can be used to identify tactical movements for the market, a sector, or sub-industry. This model (which we refer to as “HALO”) is a multi-factor model based on the advance/decline breadth for the represented group. The model can be applied to predict relative performance for the market, a sector/subindustry versus the market, one sector against another, or a subindustry relative to another subindustry or the broader sector to which it belongs.

The model attempts to predict the forward 1 – 6 month relative performance of a group in order to help generate tactical ideas for aggressive trading accounts and better time implementation strategies that would be consistent with our strategic conclusions derived from our 8-panel analysis, as well as our stock-specific Estimate Revisions Model (ERM). 

Like our other offerings, it has both momentum and contrarian characteristics. When the blue line, which is the model, is trending in a particular direction, our proprietary tool is in a momentum phase (see red and green arrows below), and our research shows with a high probability that relative performance will mirror the slope of the line, and we recommend investors avoid betting against that trend. As the model is built to oscillate, however, an inflection from an extreme reading strongly suggests that a reversal in the most recent performance trend is likely to occur (see points A and B below).