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What
stock market sector have you been in lately? The sectors that are
beating the market or the ones that are trailing behind? Being in the
right sectors will make a significant difference in the performance of
your portfolio. However, finding the right sector can be a difficult
proposition. In Part 1 I introduced the basic theory behind sector
rotation as described by Stan Stovell in Standard
& Poor's Guide to Sector Investing 1995 Quick Review of Sector RotationJeffrey
Stangl, Ben Jacobson and Nuttawat Visaltanachoti tested the sector
rotation theory described by Stan Stovell’s book Standard
& Poor's Guide to Sector Investing 1995
The following table is based on Standard & Poor's Guide to Sector Investing 1995 describes what sectors should perform best in each stage of the business cycle.
The concept is to use the economic cycle to determine what sectors to make investments. The study basically found that it is unlikely that an investor can outperform the broad stock market using the sector rotation theory described by M. Stovell. What is interesting is that the study underperformed the market in Stages I and II, the first two expansion stages. I will come back to this point later in this article. In the other study written by Robert Johnson, C. Mitchell Conover, Gerald R. Jensen, and Jeffrey M. Mercer, published in the Journal of Investing indicates that a sector rotation strategy based on the Federal Reserve rate changes could substantially improve a portfolios performance over the past 33 years. According to the study investors do better when they follow a more aggressive strategy when the discount rate is decreasing and a more defensive strategy when the Fed is raising rates. Looking at Sector PerformanceBy many measures we are in the fifth year of a bull market. As a result we should see some sign of rotations of sectors as we have moved through the years. The chart below covers the four years from October 15, 2003 to October 18, 2007 (that is as far back as the PerfChart from StockCharts.com goes). In those four years Energy has been the dominate sector beating the S&P 500 by 150%. In the sector rotation study mentioned above, investors should only invest in energy during the third and final stage of the economic expansion. While I have not performed a detailed analysis of each stage of the economy, it seems obvious that energy performed well throughout the recent economic expansion. Surprisingly Utilities was the second best sector followed closely by Materials and Industrials. According to the sector rotation chart above, investors should only consider investing in utilities when the economic cycle is in Stage IV, the first stage of a recession. Five sectors, Consumer Discretionary, Consumer Staples, Technology, Healthcare and Financials actually performed worse than the S&P 500 over the four year period.
The table below shows the performance of the key S&P sectors by Economic Expansion Stage over the same four year period compared to the performance of the S&P 500. Let’s make a couple of observations. First, Technology performed worse than the S&P 500 for the first three years. This is primarily due to the long term fall out from the technology bubble that ended in 2000. Second, only Consumer Staples, Healthcare and Utilities performed better than the prior year from October 2004 to October 2005. These would be considered conservative sectors suitable for a economic recession. Energy performed well for three of the four years, driven by the growing demand for oil and then the ever present supply concerns in regions where much of the world’s oil is obtained. Sector Performance by Year Middle of October 2003 to Middle of October 2007
My basic conclusions from this very brief analysis are:
Selecting the Right Sectors, Know the Investing ThemeThe investing theme should be clear and simple since there only a couple of key factors that determine the trend for the sector. Most of the time it involves what is driving the supply and demand for the products or services within the sector. For example in the energy sector the demand for oil throughout the world is growing as emerging economies grow rapidly and create new demands for energy. The available supply will become more expensive to find and new alternatives will be needed to keep up with the demand. From this overall theme, you can then focus on each sub-sector to assess where the best opportunities will lie. Continuing the example, the need for new supply will drive up the demand for those companies that can contribute to the exploration and development process for oil. This means the oil services companies should benefit. The chart below is of the Oil services Holders (OIH). Three years ago it was trading in the 90 to 100 range. Three years later it reached 200. A very nice return if one had identified and followed the theme.
When you are creating your theme, or borrowing from one’s you have heard and like, be sure to look up and down the “supply chain” of the sector. You might be surprised by what you find, even in a different sector. For example drilling deeper for oil requires newer and better pumps and valves. Flowserve (FLS) designs and produces pumps and valves for the energy industry as well as others. It is classified in the Industrial sector, yet it benefits from the search for oil. When
developing the theme for the sector, be sure you look at the risks that
are inherent with the theme. These risks might the trigger you need to
know when to sell, reduce your position, or switch to another sector or
sub-sector. For example, if the price of oil gets to high it is in
danger of causing the economies of the world to slow down, possibly
causing a recession. Periodicals like Barron's Periodically review your sector themes to see if they still hold and what will cause them to no longer be valid. Themes can last for many years. They also can change gradually or quickly depending on the key drivers. Place a time limit on your investment when you are using themes to guide your stock selection. As you near the time limit, review the theme to verify its continued validity. If it changes, then change your portfolio as well. Use these times to look for new sectors that logically follow your changing themes. The Bottom LineBeing in the fight sector can significantly contribute to your investing success. Investing themes are a great way to help identify what sectors for you to invest or to avoid. Themes can also be helpful when you are considering moving to another sector or sectors. Themes help to answer the question why is this sector the best place to invest. Develop themes around the basic economic situation for the sector such as supply and demand. They will serve you well as you grow your portfolio and beat the market. © 2007
Hans Wagner As a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market. Feel free to visit the site at http://www.tradingonlinemarkets.com/ CONTACT
INFORMATION The opinions of FSU contributors do not necessarily reflect those of Financial Sense. |
