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: The market had a rough start coming out of the gates to start the year. We’re dipping below the 2000 threshold. What are your thoughts on the market softness this early into the year?
Stovall: Well, it is a bit unnerving but at the same time, it’s not something out of the ordinary. With that said, it’s a concern most investors are facing right now and something I wrote about to open this week’s S&P Capital IQ's IPC Notes:
The frantic question most frequently asked after the close of business on January 4 was whether the sharp decline was an ominous omen for the rest of the year. To offset emotion, one frequently turns to data. There have been nine times since WWII in which the S&P 500 fell by 1% or more on the opening day of trading. In six of those years, the market was higher on the month, and up for the full year. For all observations, the 500 recorded a calendar-year advance of 6.2%. Separately, the S&P 500 posted a YTD decline in 87% of all calendar years since 1945. Also, one-third of all YTD lows were set in January, nearly three times as much as October, which saw the second-highest number of YTD lows. Therefore history suggests, but does not guarantee, that investors should not expect full-year results to be a reflection of opening day activity.
EQ: The S&P 500 closed in the red for 2015. We had talked about the possible implications of this in our last interview. Given that Santa Claus did not visit Broad and Wall, should investors be more cautious that a bear market could be looming?
Stovall: Yes, certainly in terms of the length of this bull market, we are getting long in the tooth. Right now, the S&P 500 has gone 82 months in this bull market. The second longest bull market since World War II was the one in 1949 that went 86 months. The longest bull market started in 1990 at 113 months. So we’re closing in on the second-longest, and we’re scheduled to celebrate the seventh birthday of this bull market on March 9 of this year. Only two other bull markets have done so. So just in terms of age, a lot of investors are thinking that the music may soon stop.
EQ: Could that serve to be a self-fulfilling prophecy in some ways if investors are trying to get ahead of everyone else?
Stovall: Well, I was thinking about that but usually bull markets end when there is a lot of euphoria, and not the other way around. Right now, most people are very pessimistic and so the thought is, if everybody’s bearish, who’s left to sell?
So maybe you have short sellers and momentum players trying to test for technical resistance levels to be breached, and thereby gain even more money when we see a negative reaction once those levels have been broken. I would tend to say that bull market tops occur when investors are optimistic, not pessimistic.
EQ: In this week’s Sector Watch report, you looked at two contrasting strategies based on performance. Investors either go with the best performers and let their winners ride, or do a bit of bottom fishing by going with the worst performers. Of the two, which one has done better on average?
Stovall: Well, if you look exclusively at the 10 sectors in the S&P 500, history says that you’re better off buying and holding in equal proportions the three best performing sectors from the prior year. Since 1991, the compound rate of growth for owning the top three sectors was 8.4% versus 7.6% for the S&P 500. This technique also beat the market about two out of every three years. The bottom three sectors, however, posted a CAGR of 6.8% and beat the market only 40% of the time.
If you take that one step further and look at the winners and the losers from a sub-industry perspective, in which there are 130 of them, you find surprisingly that it works if you let your winners ride or if you buy low and sell high later on. On average, the bottom 10 sub-industries posted a CAGR of 12.1% while the top 10 sub-industries posted a CAGR of 12.8%. Both approaches did very well, so it really is up to the investor as to whether they feel more comfortable buying those companies that have good momentum behind them or buying those sub-industries that have been priced to go out of business but hopefully don’t.
EQ: You also looked at combining the two approaches with a Barbell Portfolio. How does that work and how would investors go about building one?
Stovall: Well, I call it a Barbell Portfolio—some of my cynical friends jokingly say that I should name it after myself and call it the Dumbbell Portfolio—but it takes the two ends of the extreme. If you have 130 sub-industries in the S&P 500 then you take the top 10 and the bottom 10. Then that way, if one technique tends to outperform the market but the other does not, then you have each side of the coin supporting the other side.
It has worked because the CAGR since 1991 was 13.5%, better than each of the individual components because of correlation. Both were taking the upward trajectory, but took the stairs at different rates of pace. What’s interesting is that in every year but two (23 of 25 years) at least one of these two techniques beat the market. So if you are an investor who likes to brag about your portfolio by having two portfolios in this Barbell approach, in 23 out of 25 years you would have something to brag about.
But since there aren’t many ETFs that mimic the sub-industries in the S&P 500, what I did was I came up with individual stocks to serve proxies for each of these 20 sub-industries. I selected them by going on S&P Capital IQ’s MarketScope platform and screening for those companies within each sub-industry that had the highest ranking. If there was a tie, then I opted for the company with the largest price appreciation potential and if there was still a tie, then I selected the larger company within that category, since each of the sub-industries is a market-weighted index.
For more from S&P Capital IQ, be sure to visit www.getmarketscope.com.
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