A number of stock groups have experienced significant underperformance in the market recently, but they may be setting themselves up for a turnaround. This phenomenon, known as “mean reversion” trade, presents an opportunity for savvy investors.
Industrial Sector Takes a Hit
The Industrial Select Sector SPDR ETF (ticker: XLI) has seen a decline of just over 3% in the past month. This slump is worse than the overall market performance, as reflected by the S&P 500, which has retreated roughly 2.8% during the same period. The main culprit behind this downward trend can be attributed to rising interest rates.
Materials Sector Falters
The Materials Select Sector SPDR ETF (XLB) hasn’t fared much better, experiencing a nearly 5% decline in the past month. With manufacturers heavily relying on strong demand for their products and services, this drop can be seen as a consequence of rising interest rates and the subsequent impact on the broader economy.
Consumer Discretionary Takes a Hit
The Invesco S&P 500 Equal Weight Consumer Discretionary ETF (RSPD) has also felt the sting of underperformance, sliding just over 6% in the past month. With consumer spending impacted by a decrease in disposable income, companies in the consumer goods and services sector have taken a hit.
A Cautionary Tale
The Federal Reserve’s rate hikes, totaling 5.25 percentage points since March 2022, have contributed to the downturn in these stock groups. While this tightening monetary policy is expected to have a gradual impact on the economy, the rise in yields on longer-dated debt over the past month has added to the challenges faced by these sectors.
An opportunity may be on the horizon for investors who see potential in these underperforming groups. Despite their vulnerability, there is potential for a rebound if the factors that have contributed to their decline stabilize or reverse.
Stocks Poised for a Rebound
Data from 22V Research suggests that stocks which have underperformed the S&P 500 in a given month often experience a rise in value shortly thereafter. This phenomenon occurs because their previously discounted prices return closer to the average or recent trends.
According to Dennis DeBusschere of 22V Research, implementing a strategy of longing the worst performers from the previous month and shorting the best performers has historically been successful more than half of the time.
In fact, 22V Research has a “mean reversion portfolio” that tracks stocks in a specific percentile of underperformance over the preceding month. This portfolio has demonstrated periods of high returns, such as a 15% gain during a multiweek stretch earlier this year.
When underperforming stocks become cheaper, it often encourages market participants to purchase shares at discounted prices.
While underperformance reflects concerns about earnings and the economic outlook for these companies, it is important to remember that nothing in the market is certain. There is still a probability that the economy will remain resilient. Consequently, some investors see an opportunity and choose to buy these beaten-down stocks because their prices already incorporate the potential impact on profits.
This increased buying activity has the potential to push these stocks upward in the short term. It may be worth exploring these funds further.
Written by Jacob Sonenshine