Tuesday, January 16, 2007

XLE and XLK: When Energy and Technology Move in Different Directions

Over the past month, we've seen the energy sector, represented by the XLE Spyder ETF, and the technology sector, represented by the XLK Spyder ETF, move in different directions, with technology strong and energy weak, due to falling oil prices. On the surface, this would seem to be a bullish sign, as money is pouring into growth areas as the costs of energy are declining for businesses and consumers.

Actually, since 2004, the correlation of daily price changes between XLE and XLK has only been .26. XLE is sensitive to oil and other energy futures prices and only correlates .51 with the S&P 500 Index (SPY). XLK trades more like a traditional stock sector and correlates .81 with SPY on a daily basis. Because only about 7% of the variance in daily price movement is shared between XLE and XLK, it is not unusual to find time periods in which--as present--XLK is strong, but XLE is weak.

Since 2004 (N = 743 trading days), we have had 123 occasions in which XLK has been up over a five day period, but XLE has been down. Over the next ten days, SPY has averaged a gain of 1.0% (93 up, 30 down). Across the remainder of the sample, SPY has averaged a ten-day gain of .20% (360 up, 260 down). It thus appears that short-term returns have been superior when money has been flowing into technology and out of energy.

When we look over a 20-day horizon, we see similar results. When XLE has been down over 20 days, but XLK has been up (N = 94), the next 20 days in SPY average a gain of 1.80% (82 up, 12 down), quite a bullish edge. Conversely, for the remainder of the sample, SPY averages a 20-day gain of .46% (397 up, 252 down). Once again, money flowing into tech and out of energy has been quite bullish for the S&P large caps going forward.

My best take on this situation is that the flow of funds within the sectors captures short-term sentiment among portfolio managers. When energy prices are falling, this is deemed positive for the market and--when sentiment is positive--some money leaves the energy sector and seeks a home in more growth-oriented vehicles. When XLE is falling and XLK is rising, market participants are more bullish on growth--and this sentiment appears to carry forward in the short run. That has been a bullish indication for the present market.