In my new book The Seven Rules of Wall Street, which will be published by McGraw-Hill in February, I show how to use old rules of thumb to develop market-beating portfolios. The first of these rules, "Let your winners ride, but cut your losers short," demonstrates the importance of sticking with the sectors and industries that have beaten the market over the past 12 months, while avoiding those that have faltered.
Besides reminding you that there is no guarantee that what worked in the past will work in the future, remember that no investment discipline works all of the time. The "Let your winners ride" rule (using S&P 500 industries) has beaten the Standard & Poor's 500-stock index by an average of 700 basis points per year since 1970, and has bested the market approximately 70% of the time. Obviously, it underperformed 30% of the time. Knowing when it lagged, however, is the basis of this story.
Priced to Fail
At market bottoms, there are relatively few places to hide. Since World War II, all sectors in the S&P 500 have posted declines on average during bear markets as many companies and subindustries were priced to go out of business. Yet when the market began to turn around, and these beaten-up companies and subindustries had not gone out of business, they represented very attractive investment opportunities.
Since World War II, had an investor purchased an equal weighting of the 10 S&P 500 subindustries with the worst trailing 12-month price performances at the bottom of the most recent bear market and held them for a year, their portfolios would have recorded an average price advance of 57% vs. the S&P 500's average gain of 36%. What's more, these bottom 10 subindustries as a group posted annual increases that beat the market 90% of the time. The 10 subindustries with the highest trailing 12-month price change as of the bear market bottom went on to post a respectable average year-ahead price advance of 33%, but bested the "500" only 30% of the time.
In other words, while investors traditionally have been better off sticking with leading sectors and subindustries, history indicates (but does not guarantee) that at the bottom of a bear market, it has been more profitable to make an exception to this rule.
So if an investor were brave enough to purchase the 10 most badly mauled groups during this recent bear market, which would they be? Before I reveal the list, we need to agree on two things: 1) the bear-market low has already been established, and 2) we will soon get a more attractive entry point, since the S&P 500's 2008 year-end close of 903 is already 20% above the Nov. 20 low.
S&P's Investment Policy Committee believes the Nov. 20, 2008, close of 752 on the S&P 500 was the likely low of this mega-meltdown, as we think it reflected investors' deepest concerns about the global recession and its impact on worldwide corporate profits. But we don't expect the new bull market to take off like a lunar launch. We also project that this bottom will likely be retested, thus dragging the S&P 500—and a majority of sectors and subindustries—through another emotional roller coaster ride before we are more confident that the bottom has been put into place. Once this has occurred, however, it may be the opportune time for more risk-tolerant investors to embrace this previously profitable exception to an old Wall Street truism.
As of Nov. 20, the S&P 500 subindustries that posted the worst trailing 12-month price performances were Aluminum, Automobile Manufacturers, Casinos & Gaming, Consumer Electronics, Diversified Metals & Mining, Industrial REITs, Investment Banking & Brokerage, Multiline Insurance, Thrifts & Mortgage Finance, and Tires & Rubber. They each recorded 12-month declines ranging from 80% to 97%.
The following 10 stocks were selected to serve as proxies for these respective subindustries. They are companies that currently have the highest S&P STARS. In the case of a tie, the issue with the highest market value was selected: Norsk Hydro ADR (NHYDY; 4 STARS, buy), Ford Motor (F; 3 STARS, hold), MGM Mirage (MGM; 3 STARS), Harman Intl. (HAR; 3 STARS), Compass Minerals Intl. (CMP; 4 STARS), Prologis (PLD; 4 STARS), Charles Schwab (SCHW; 4 STARS), Loews (L; 3 STARS), Hudson City Bancorp (HCBK; 5 STARS, strong buy), and Goodyear Tire & Rubber (GT; 4 STARS). Should history repeat itself, and there's no guarantee it will, this list as a group may end up outpacing the S&P 500 should we indeed be in the first year of a new bull market.
Last Year's Winners
For those investors who prefer to stick with the winners, here they are. As of Dec. 31, the 10 subindustries that posted the highest 12-month price changes were Automotive Retail, Biotechnology, Brewers, Education Services, Environmental & Facilities Services, HyperMarkets & Super Centers, Insurance Brokers, Metal & Glass Containers, Restaurants, and Specialized Consumer Services. Either way, good luck.