Rule #1 Let Winners Ride, Cut Losers Short

The old rule of “buy low, sell high” usually doesn’t work in the short-term.    It has been far more rewarding to invest in markets and industries that have posted strong recent performance, rather than attempting to buy on weakness.

In The Seven Rules of Wall Street, Sam Stovall suggests that the best performing stocks belong to the best performing sectors and industries of the past year.

To explain further, we need to clarify some terminology.

The 500 companies in the S&P 500 index are divided into 130 industries and 10 sectors.  Industries are specific, sectors are broad.  Soft drink manufacturers, brewers, tobacco companies, and household products are all separate industries, but are considered to be part of the same sector – consumer staples.  Other sectors include technology, utilities, and financials.

What determines a stock’s performance?  Eighty-percent of a stock’s returns are correlated to the performance of its industry.    The implication is that investors need to pay just as much attention getting their industry selection right as they do researching individual companies.

Stovall offers two strategies.

The first strategy is sector-based.  Stovall buys the top two (out of ten) sectors of the previous year at the beginning of each January and holds them for exactly one year.  The next January, he sells them and then buys the top two performing sectors of the previous year.  An easy way for investors to approximate this strategy would be to use the S&P Sector SPDR ETFs.

The result – this system beats the S&P 500 71% of all years between 1990 and 2007, and adds an incremental 1.6% in returns annually.  The system carries similar risk to the market.

The second strategy is industry-based.    Stovall buys the top ten (out of 130) industries each January 1st, and holds for one year.  The next January he replaces them with the top ten industries of the previous year.

This system beats the S&P 500 71% of all years between 1970 and 2007, by average of 6.1% per year, with somewhat higher than market levels of volatility.

This is a BIG deal.  The industry-based system boosts the compounded annual growth rate of an investment from 7.6%  to 13.7% — almost doubling the growth rate on an annual basis.

One lesson from this is that granularity counts.  A smaller slice of the investment pie sometimes offers sweeter returns.

We’ve got a problem, though.  There is no easy way to invest in each of the 130 S&P industries.  Stovall suggests using S&P STARS rankings to cherry-pick the best stocks within each industry.  Stovall seems to be “talking his book” here and only mentions S&P products and strategies.

A simple, yet highly effective approach would be to apply the same strategy using the Fidelity Select funds.  By purchasing the top two Fidelity Select funds from the previous calendar year and holding for twelve months, it is possible to achieve nearly the same results of the industry rotation model with less fuss and fewer transactions.   In my own studies, using Fidelity Select funds in this manner outperformed and S&P 500 index fund by 5.7% percent per year from 1997 to 2009 with slightly less volatility.  Interesting, no?

Granted, Stovall introduced this idea prior to joining Standard & Poors.  It doesn’t help their marketing department, but it still works just fine…

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