Rule #2 As Goes January, So Goes the Year

Here’s an inside scoop on sector investing – nothing succeeds like success.

At the end of each January, when S&P equity strategist Sam Stovall is asked to predict the best performing sectors and industries for the coming year, he looks at their performance for the previous month.   What performs well in January tends to do well the remainder of the year.  He finds that no other month works as well as a year-ahead indicator.  This applies not only to industry selection, but to market direction as well.

Looking at data from 1945 through 2007, Stovall finds that if the S&P 500 declines in January, it declines by an average of 0.7% during the next  11 months.  This indicator has posted some big misses in 1982 and 2003, when the S&P fell in January, but the market rose by 16.8% and 29.9% during the next 11 months, respectively.

The “January” indicator is 85% accurate in predicting “up” years and 45% accurate in predicting “down” years.  Better than a coin toss, but I wouldn’t run a portfolio based on this indicator alone.

Similar to the Let Winners Ride, Cut Losers Short strategy (see previous post), Stovall implements this strategy using S&P 500 sectors and industries in his book The Seven Rules of Wall Street.

Here is the Strategy:  At the end of each January, Stovall buys the top three performing sectors of the previous month, and holds for the next year.   When backtested for the 1970 through 2008 time-frame, this strategy generates a compound growth rate of 12.4% vs. 8.3% for the S&P 500 – an incremental improvement of 3.9%, beating the market 75% of all calendar years.  Not bad.

Alternatively, he buys the top ten industries of the previous month at the end of each January and holds for one year.  This generated a compound growth year of 15.9% per year vs. 7.6% for the S&P 500, beating the market 71% of all calendar years, by an average of 8.3%.  Yes, that is doubling the return of the market on an annualized basis.

There are plenty of reasons why this strategy works – but the most reasonable is that investors tend to make investments based on recent past performance.

The big appeal to this strategy is that it allows you to “set it and forget it”.  You can make one allocation decision a year and  still blow away the performance of the market.

Again, industry rotation seems to work better than sector selection.    What is interesting is that this strategy seems to work better (and with fewer data points) than one that uses a full year worth of hindsight.

The same problems exist here – there is no convenient way of buying each of the S&P 500 industries in ETF form — only the most popular industries are available.  I suspect that similar results could be generated by using the Fidelity Select Funds.    In this case, I would consider using the two top performing Fidelity Select Funds for the month of January, and hold them for the next twelve months.

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