Friday, February 24, 2006

Semiconductors and QQQQ: An Example of Complexity

I've received quite a few emails regarding the last few entries dealing with lead-lag relationships between sectors/markets and the major trading indexes. Rarely are these relationships simple one-way affairs. Whether a sector leads or lags the trading index depends upon at least two crucial factors:
  • Time Frame - A sector may be unrelated to an index on a very short-term basis, but still be predictive further out. For instance, many of the analyses are more powerful when predicting several days out than predicting next day.
  • Whether the Predictor Sectors/Markets Are At Extremes or Moderate Values - Most often, a sector will not be equally predictive at very high and very low levels (extreme values) and at moderate levels. Analyses need to focus on a relevant segment of a predictor's distribution (a range of values similar to the current values), not the full distribution.

Here's a good example. We recently saw a leading relationship between the semiconductor stocks and the S&P 500. As of Friday's close, the semiconductor stocks (SMH) was down sharply on a two-day basis (down over 1.5%), while the NASDAQ 100 Index (QQQQ) was unchanged. In this situation, the SMH weakness ends up not leading the QQQQ lower. After a sharp two-day drop, most the indexes tend to rebound, which in this case would benefit the QQQQ.

We see that, since March, 2003 (N = 749), there were 90 days in which the two-day QQQQ neither rose nor fell by more than .20%. The next four days in QQQQ averaged a gain of .32% (51 up, 39 down), not significantly better than the average two-day gain of .30% for the sample overall.

When we split the sample in half based on SMH performance over the two days, we see a pattern. When SMH has been strong, the next four days in QQQQ average a gain of .11 (24 up, 21 down). When SMH has been weak (as recently), the next four days in QQQQ average a gain of .53% (27 up, 18 down). An examination of the data suggests that this occurs primarily because of a bounce back in SMH, which helps QQQQ.

What we're seeing is evidence of complexity. Trading relationships among sectors, stocks, and markets is not so simple as saying, "A leads B." One must specify the conditions under which there is a leading relationship. I have been encountering this same complexity with the earlier mentioned Speculative stocks and will report on that this weekend.