Rule #5 There is Always a Bull Market Someplace

So far, we have looked at fairly passive strategies from the book The Seven Rules of Wall Street – techniques that generate trades only once per year.   This simple strategy will enable you to keep up with trends on a more regular basis.

It pays to stay in sectors and industries that are outperforming the market.  Even in bear markets, stocks with good relative strength tend to lose less money. 

This is a variation of the Let Your Winners Ride strategy, so it may be worth reviewing that first before proceeding further.

The Strategy:  At the beginning of each month.  Buy the top (3) performing sectors or the top (10) industries from the past twelve months.   Review one month later.  Continue to hold if these remain best performing areas.  Otherwise, sell and buy the top ranked choices.

The Results:   During the 1991-2007 time frame, the top performing sectors portfolio grew 13.4% compounded annually versus gains of 9.2% for the S&P 500.  Volatility was similar to the S&P 500.

Meanwhile, the top performing industries generated returns of 20.1% per year – beating the market by a whopping 10.9% annually.   Volatility was twice that of the market, but this strategy still generated better returns than the market even on a risk-adjusted basis.

Both strategies outperformed the market 70-75% of all calendar years.

One caveat – these strategies generate high turnover.   200%-300% churn per year means that it only really makes sense for retirement accounts.  The industry strategy generates 30 swaps per year (selling something to buy something else), so trading costs could eat into smaller accounts.

Finding the best performing sectors is fairly easy – just go to www.sectorspdr.com and get the price performance of their nine sector ETFs.  For the best performing industries, you may need a subscription to www.spoutlook.com.  (I get my data from Reuters and import to MetaStock.)

Overall this is an impressive strategy and is one of Sam Stovall’s favorites.  It is simple, consistently outperforms the market by a broad margin, and offers superior risk-adjusted returns.

The problem is that it leaves money on the table  – the trailing twelve-month period also may not actually be the optimal lookback period.

An alternative approach developed by David Vomund in his book ETF Trading Strategies Revealed is somewhat more difficult to implement, but seems to offer better results.  Vomund uses the Fidelity Select funds for his industry exposure.  Every two weeks, he ranks the universe of Fidelity Select Funds (39 of them), based on their performance during the most recent three months, and the three months before that.  The most recent 3-month performance receives a double weighting.   He buys the top 2 ranked Fidelity Select Funds.  Here is the formula for fund rankings:

((recent 3 months percent change*2)+(older 3 month percent change))/3

He sells a position only if a selected fund drops below the top half of the group, and replaces with the top ranked fund.  This reduces portfolio churn.

The result is a compound return of 12.0% from 2000-2009 vs. -1.2% for an S&P 500 index fund, or about 13.2% worth of annual outperformance.   It beat the market nine out of ten years.  (In 2006 it lagged the S&P 500 by slightly over 1%.)

Vomund’s approach takes little more calculation, but seems to offer greater consistency and better returns.  Looks good to me.

Click here for the results of his strategy…

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