Editor's Note: Minyanville is proud to introduce our newest professor, Vinny Catalano.  Vinny Catalano is is President and Global Investment Strategist with Blue Marble Research and author of Sectors and Styles: A New Approach to Outperforming the Market.

Portfolios that benefited from being underweight Consumer Discretionary and Financials, the two sick men of the US economic sectors, were faced with a performance-related decision this summer: Play the potential counter trend rally or sit on the sidelines and watch relative performance suffer?

Take, for example, Consumer Discretionary. As the chart shows, the mega trend (price in relation to moving averages; moving averages in relation to each other and the slope of both moving averages) for it is solidly negative.


Click to enlarge

Yet, for the moment the counter trend move shows that it has been substantial enough to warrant a near even weighting.

If a managed portfolio was wisely underweight the sector and advocated the actively managed approach, the advisable decision would have been to increase the exposure to the sector at or around its recent oversold levels (similar to January of this year), when price was substantially below its 200 day moving average, for example.

(There are other, more “sophisticated” methods of measuring oversold/overbought levels: The above-referenced price to 200 day moving average is one rather simple method.)

Investment Strategy Implications

Regression to mean works both ways, for up and down trends. Overshooting is a common characteristic of trending markets. Counter moves occur that bring price back to its downtrend (regress to its mean) can be, at times, substantial.

For actively managed accounts, this presents the decision-making dilemma of whether to ride out the counter trend move (and lose some alpha) or play a game of chicken – knowing when to enter and then exit from a sector that you really don’t want to be in.

Getting in is largely a technical analysis decision – when an issue reaches a seriously enough oversold level (There are also other factors involved, including timing methodologies such as a divergence between price and momentum indicators).

The magnitude of getting in (how much to add) involves portfolio allocation decisions including the effects on the overall portfolio’s risk tolerance (aggregate portfolio beta, for example).

Getting out (which is where we're at currently) could be a technical analysis decision, but given the longer-term view that this is a sector to be avoided, the benefits achieved thanks to the rally from oversold levels would encourage me to begin lightening up, taking my short-term profits and bring the sector allocation level back down to its pre-rally underweight levels.

Loving what you hate is no fun, but for actively managed accounts playing a game of chicken can be a useful, if not necessary, option.