Stocks: The Third-Year Turnaround

Industries with two consecutive losing years tend to bounce back in the third. Which groups could rebound in '08?

Could the third time be the charm for slumping subindustries? At the beginning of this year, someone asked me which S&P 500 subindustries had fallen in 2006 and 2007, implying that groups that had suffered declines in two successive years would bounce back in year three. I responded, but didn't follow up on my curiosity—until now.

So far this year (through Mar. 20), 102 of the 130 subindustries of the S&P 500 have declined in price. I thought it might be worthwhile—from a contrarian standpoint — to see which groups had fallen in 2006 and 2007 (and down again 2008), as well as perform a study to see if buying an index after two years of successive declines would have proved to be a good trading strategy in general, knowing full well that what worked in the past may no longer work in the future.

I started by charting a histogram of the count of subindustries showing their greatest number of successive annual declines from 1990 through 2007 (see accompanying chart). I was surprised to see that 36 of 130, or nearly 30% of the subindustries in the "500," recorded three, four, or even five years of declines in a row. I was also surprised that 39 groups never saw successive years of price declines in the 18-year stretch.

Six subindustries posted no price declines in any year, but that was because these indexes are fairly new and have been around a maximum of only four years.

Solid Cushion of Outperformance

Even though the histogram indicated that the hypothesis may be false, I decided to perform the analysis anyway, and came away with slightly encouraging results. Starting in 1992 with subindustries that had posted price declines in 1990 and 1991, I found that an equal weighting to subindustries with trailing two-year price declines provided an average annual price advance of 12.8%, vs. the S&P 500's average price gain of 9.4%.

In other words, the "Third Year Charm" (TYC) list beat the broader market by an average 340 basis points per year, offering what appears to be a solid cushion of annual outperformance. The 56% frequency with which this TYC list beat the market left a bit to be desired, however, as it was not much better than a coin toss. The list was manageable, in our opinion, with an average holding of 10 subindustries. In addition, seven subindustries rose each year, on average, while three fell.

So which subindustries made the list for 2008? There were seven: Airlines, Biotechnology, Electronic Manufacturing Services, Homebuilding, Home Improvement Retail, Specialized Consumer Services, and Wireless Telecommunications, clearly implying the possibility of a recovery for several subindustries that are members of the Consumer Discretionary sector, in our view.

So there you have it. Investing in those S&P 500 subindustries that posted negative results in the prior two calendar years has provided an average 340 basis points of excess annual return vs. the S&P 500 in the past 18 years, but has delivered a less-than-inspiring 56% frequency of market outperformance (as well as the reminder that past performance is no guarantee of future results).

Industry Momentum List Update

Here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the 136 subindustries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P Stars Rank Price (3/20/08)
Coal & Consumable Fuels Peabody Energy BTU 3 47
Computer Hardware IBM IBM 5 118
Construction & Engineering Fluor FLR 4 131
Diversified Metals & Mining Freeport-McMoRan Copper FCX 3 87
Fertilizers & Agricultural Chemicals Monsanto MON 3 97
Industrial Gases Air Products APD 3 90
Integrated Oil & Gas Exxon Mobil XOM 5 85
Internet Retail AMZN 3 73
Marine Kirby Corp. KEX 4 54
Oil & Gas Drilling Noble Corp. NE 5 47
Oil & Gas Equipment & Services Baker Hughes BHI 5 66
Oil &amp Gas Exploration & Production Swift Energy SFY 5 43
Railroads CSX CSX 4 55
Soft Drinks Coca-Cola KO 5 61

Source: Standard & Poor's Equity Research

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