Pill Bottles and Oil Barrels: A Perversion of Mean Reversion and Excursion Part I

I never thought my inaugural piece in BlogoLand would be without a conclusion. Nevertheless, there IS a trade here, so my only attempt would be to find actionable ideas given that one of two possible situations must unfold.

1) Biotechs continue to massively outperform Oil Services companies (Excursion)  OR

2) We’ve reached (or are soon to reach) an extreme, and it all comes crashing-in (Reversion).

Here is a chart of the Amex Biotechnology Index (BTK Index) from Inception:

And here is a chart of the S&P 500 Oil Equipment and Services Index (S5OILE) from Inception:

Here is a chart of the ratio of first chart divided by the second chart, a measure of the relative performance of the two industries:

Clearly we are at or near an extreme. For aggressive investors, there is precedent for such extremes to become even more extreme. For patient investors, there is just as much precedent that we are near the point where it all comes crashing in.

Here are the facts:

• The BTK has outperformed S5OILE by more than 100% for five weeks in a row (currently 104%).

• This has only happened four other times since the inception of the S5OILE index in 1989.

• It happened between 12/5/08 and 2/20/09 and lasted 11 weeks for a max excursion of 161%.

• It happened between 12/31/99 and 2/25/2000 and lasted 8 weeks for a max excursion of 245%.

• It happened between 12/6/91 and 1/10/92 and lasted exactly five weeks for a max excursion of 144%.

• It happened between 9/13/91 and 9/20/91 and lasted, well… 1 week, for a max excursion of 142%.

• Max excursion is defined to be the peak relative outperformance of BTK vs. S5OILE.

• The time that this excursion “lasted” (mentioned above) refers to the instance when this outperformance first breached 100% until it reached its highest peak. Thus, we are looking at just the extreme part of this outperformance. 

So… if you are highly tactical and aggressive and think there is another 50-100% of Biotech outperformance (entirely reasonable based on the facts), then you go long Biotechs and short Oil Services for the next several weeks.

From the above we see that, in terms of time, we are right around the middle of this pathetically small sample (5 weeks). From a price perspective, we are nowhere near the extreme which has averaged 173%. The biggest caveat here is that it is possible we have already reached our extreme this time around in early March - at 124%. Thus, there has been some reversion already. We don’t know if this is “IT”, as there is also precedent for the reversion to exceed 20%, only to go back into excursion mode and reach a “higher high”. We define a reversion as having officially “crashed in”, when it exceeds 40%, as it has every time, after every peak.

Bryan Franco