As Sam Sees It: A Refresher on the Rules of Wall Street

Sam Stovall |

Sam Stovall S&P capital IQ chief equity strategist

Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

EQ: With 2012 getting underway, we thought it would be a good idea for investors to take another look at the strategies in your book, The Seven Rules of Wall Street. Which rules worked best for investors last year?

Stovall: I guess it's always good to have what I call the "seven rules of Wall Street" because you have to have at least one of them that works well each year, and it might not always be the same one. You can pretty much describe the rules in three different ways:

1. Market Momentum: These rules say that investors are better off sticking with last year's winners than last year's losers. So, in a sense, you go with the flow.
2. Sector Diversification: The second philosophy is investing in sectors that have very low correlations with one another, and therefore, adhering to the tried and true approach of diversifying among low-correlated assets, or in this case, low-correlated sectors.
3. Seasonal Trends: This rule is about identifying and leveraging seasonal aspects we see within the overall marketplace.

The two that seemed to work best in 2011 were the seasonal and low-correlation strategies. By seasonal, we mean the "Sell in May" strategy, which says the market does poorly from May to October, gaining only 1.2 percent on average since 1945, but does much better from November through April, gaining 6.8 percent on average.

This is not a hedge fund approach, however. We don't expect the returns to be positive when the markets are lower, but by rotating into the more defensive sectors like Consumer Staples and Healthcare from May through October, investors are engaging in capital preservation by sticking with the lower beta, more defensive sectors during the weaker seasonal period market, and then gravitating back to the market, or even emphasizing the more cyclical sectors from November through April.

In all four cases when looking at the S&P 500, S&P 500 Equal Weight Index, S&P Small Cap 600, and S&P Global 1200 as benchmarks, embracing the defensive approach with Healthcare and Consumer Staples from May through October outperformed being in the benchmarks through all 12 months of the year.

EQ: How did the low-correlation sector strategy perform?

Stovall: This approach engages in investing in low-correlated sectors and is what I call a "free lunch" portfolio, because you end up getting something for nothing. Investors end up getting higher returns with lower risk, and in this case, what I would do is invest one-third in Consumer Staples, one-third in Energy and one-third in Technology, then rebalance annually. All four approaches outperformed their respective benchmarks. What's interesting is that in 2011, while each of those four benchmarks posted declines in price, all four of these "free lunch" strategies posted positive returns in price. That certainly was encouraging, to see that in a slightly down year there was a strategy that posted gains in all four occasions. So I'm happy to report two of the three disciplines--seasonality combined with low-correlations--succeeded in 2011.

EQ: Obviously, no investment strategy ever works 100 percent of the time. Can you talk about some rules that did not perform well in 2011?

Stovall: I guess if I'm going to brag about what works, I have to admit to what does not work. In 2011, the momentum-based strategies did not work. Studies produced over the last several years show that using trailing 12-month relative strength tends to be the better way to select stocks and sectors, from a momentum perspective. In a sense, you let your winners ride. So you look back over the last 12 months to decide which were the better-performing sectors to buy, and then hold them for the coming 12 months. The "let your winners ride" approach is a static UIT-like approach where investors look back to the prior calendar year at the start of January, then buy and hold the best-performing sectors for the coming calendar year.

A more dynamic approach to this is what I call, "There's Always a Bull Market Someplace" in which every month you look back 12 months, modify your portfolio depending upon which sectors have improved in relative strength, and get rid of those that have weakened in terms of relative strength. If you look at all four benchmarks, these momentum strategies underperformed against their overall benchmarks in 2011. So, as I said before, it's good to have seven rules because at least some of them will work. Also, in a secular bear market, which we have been stuck in since late 1999, I usually find that the shorter-term seasonal approaches combined with the low-correlation strategies tend to work better than those that rely on longer-term momentum. This is because in a secular bear market, I don't think investors are willing to stick around long enough to allow a long-term momentum strategy to gain traction.

EQ: So as investors try to fight through 2012, and there isn't expected to be much economic growth, do you recommend sticking with the seasonal and low-correlation approaches?

Stovall: I think that the trend is your friend until it ends, and the trend right now is sticking with the seasonal approaches. Right now, we are in a very favorable cyclical seasonal period from November through April. What we find is that the cyclical sectors in general tend to do well. In particular, Consumer Discretionary, Industrials, Technology and Financials are among the stronger sectors. S&P has overweight recommendations in three of those cyclical areas: Consumer Discretionary, Industrials and Technology.

Also, now that we are in the first quarter of this new calendar year, history says but does not guarantee that cyclicals tend to do the best and the defensives actually end up losing money in the first quarter. On average since 1990, Consumer Staples, Healthcare, Telecom and Utilities have declined in price while the market itself has risen and the cyclical sectors have outperformed.

EQ: Another one of your rules is to, "Don't Get Mad, Get Even." What do you mean by that?

Stovall: I like to ask people, "When does 10 percent equal 50 percent?" The answer is when you're dealing with a cap-weighted index. Only 10 percent of the companies in the S&P 500--the top 50 companies in terms of market cap--represents 50 percent of what happens in the price movement of the S&P 500. So in that case, why even bother having the other 450 companies if they're being so dominated by these top 50 companies? One might even say that it's undemocratic to allow so few to have so much influence over the rest of us.

So what I would say is to gravitate toward the S&P 500 Equal Weight Index, and thus don't get mad, get even. In this case, investors can focus on an index where each company has the same representation or the same impact on the price change of the overall index. A good example would be if Big Lots, Inc. (BIG)--which has a market cap of $2.5 billion--had the same impact on the S&P 500 as Big Blue, which is the nickname for IBM (IBM). So using the blue chip stocks within the S&P 500, investors can end up with smaller-cap type performances. From 2000 through 2011, the average price change for the S&P 500 has been 0.6 percent. Yet the average price change for the S&P 500 EWI has been 6.7 percent. In addition, the equal weight index outperformed the cap-weighted index 75 percent of the time. Of course, there's no guarantee that you'll get this level of outperformance in the years ahead, but what it implies is that if you can handle volatility, over the long term you are better off with smaller companies because they have greater growth potential.

EQ: We've talked a lot in the past about higher volatility in the market now with ETFs and high-frequency trading. How has this impacted the old philosophy of buy-and-hold investing?

Stovall: Since volatility has been so high, it says that you buy and then hold very tightly, and maybe even close your eyes a little bit along the way. I say that because volatility has been a lot greater recently than it has been over time. In 2011, there were 21 days in which the S&P 500 declined by 2 percent or more. On average, from 2000 through the end of 2010, we had 15 times per year in which the S&P 500 experienced a more than 2 percent decline in a single day. If you go back to 1950, the average was 5. So the long-term average is 5, the intermediate average is 15, but last year we experienced 21. So in other words, we have a lot more white-knuckle moments for investors. So pretend you're on a rollercoaster ride and therefore you have to hold on that much tighter in order to remain in your seat.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
BIG Big Lots Inc. 47.02 0.80 1.73 527,636
IBM International Business Machines Corp 156.57 2.59 1.68 1,488,686
VCEL Vericel Corporation 2.76 -0.02 -0.54 74,385

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