There’s Always a Bull Market Somewhere

“Taking a buy-and-hold approach with sectors is like buying a Ferrari and then driving behind a school bus the rest of your life,” so begins Chapter 5 of Sam Stovall’s book, The Seven Rules of Wall Street.

Without a doubt, if I had a Ferrari I would not want to drive behind a school bus ever. So, clearly I was intrigued by this. Here’s a bit of background about Sam Stovall, whom I had a pleasure to meet recently. Stovall is a chief investment strategist of Standard & Poor’s Equity Research, and his famous book, Standard & Poor’s Sector Investing: How to Buy The Right Stock in The Right Industry at The Right Time, published in 1996, is out of print, but can be found on Amazon (AMZN).

To our mutual delight, Sam and I found that our investment philosophies overlap since we are both strong believers in sector investing. Of course, there are differences in our analyses, but the larger frameworks of sector investing works really well for us.

So, back to the Ferrari. Chapter 5 of his book focuses on the idea that some sectors always outperform the overall market on an absolute or relative basis, and these sectors are experiencing their own bull market.

It makes sense since the 10 sectors that make up the S&P 500 have various absolute returns, relative to the S&P 500 returns. Since the S&P 500 is a market-weighted average of all 10 sectors, one sector will always outperform another and/or the S&P 500 index itself. Conversely, another sector will always underperform another and/or the S&P 500 index itself. The beauty for the investor is that alpha is always available.

Stovall’s suggestion is based on the fact that many investors use a tactical asset allocation approach and invest based on the trailing 12-months price performance. The analysis is quite straightforward. You calculate the last 12 months performance of the S&P 500 GICS sectors as represented by their corresponding ETFs: Consumer DiscretIonary Select Sector SPDR (XLY), Consumer Staples Select Sector SPDR (XLP), Energy Select Sector SPDR (XLE), Financial Select Sector SPDR (XLF), Health Care Select Sector SPDR (XLV), Industrial Select Sector SPDR (XLI), Materials Select Sector SPDR (XLB), Technology Select Sector SPDR (XLK), Utilities Select Sector SPDR (XLU).

Rank them and invest in the top three performers for the last 12 months. Hold your portfolio until the next month, where you repeat the process and invest in the newest top three performers of the past 12 months.

For example, if you calculate 12-month price performance for the nine SPDRs as of end of March, here is what you would have:

I always add SPDR S&P 500 ETF (SPY) so as to compare relative to the index performance and Excess Return.

The top three sectors are XLK, XLY and XLP. this scenario suggests to buy and hold these names until the following month, at which time, I would recalculate.

This is a simple and elegant method, but let’s see if it works. I have recreated this analysis and a “What if?” spreadsheet. I run the full analysis with numbers going back to the beginning when these ETFs, that correspond to the S&P 500 sectors, became available, which is December 1998. That means that I could have only started investing at the end of December 1999.

The results were quite interesting for the period of January 1999 to March 2012. The hypothetical portfolio returned 48.5%, while SPY returned 18.4%. The volatility was the about the same. But, of course, the risk-adjusted ratio of the portfolio was more than double the benchmark.

Results – Jan 2000 – March 2012

The portfolio outperformed SPY 83 out of the 147 months for a 56% hit ratio.

I find Sam Stovall’s work so endearing because we at Rockledge do a very similar exercise by ranking the sectors and rebalancing them on a regular basis. The difference is that our Sector Scoring and Allocation Methodology (SectorSAM) has a more strategic asset allocation approach vs. the above tactical asset allocation approach, as we invest on a longer-term basis. The other major difference is that our analysis is based on fundamental analysis of the S&P 500 constituents and, thus, is the bottom-up analysis.

Quite few variations and permutations of this methodology exist, such as investing in different number of sectors more or less than three, a shorter time analysis instead of the twelve-month cutoff, various weighting mechanisms, fundamental vs. technical analysis, etc. The bottom line is that the portfolio results are quite nice for the simplicity of the method and ease of the execution.

Sam Stovall is a pioneer and deserves tremendous respect for educating and promoting sector investing. Sector investing is a better way to invest for an educated and wise investor because sector investing removes individual company risk, smoothest returns and reduces volatility.