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: Momentum is usually a term more fit for active traders, but in this week’s Sector Watch report, you talked about how investors can use it to their advantage as well. In this case, how do you define momentum?
Stovall: I define momentum by looking at trailing 12-month price changes for the sub-industries in the S&P 500. The top 10 (out of 132) are the most attractive. I find that a 12-month look-back provides the greatest overall return with the lowest amount of volatility or turnover. Basically, it’s best to look back a whole year rather than simply looking back at a couple of weeks or months.
EQ: This is counter to the “buy low and sell high” adage that investors have heard ad nauseum. Wouldn’t conventional wisdom suggest that investors would take profits on the best gainers in the market?
Stovall: Studies have shown that investors are usually too quick to take profits, but hold on to their losers too long. So, this is sort of like the old adage of “Let your winners ride.” You don’t want to hold on to winning stocks forever, but if they’ve had good momentum in the past year, chances are they will continue to have positive momentum in the coming 12-month period.
But that’s also the reason why you buy 10 sub-industries rather than simply buying one or two because if some of the sub-industries do end up losing steam, you have many others that can help carry them forward.
EQ: What kind of performance would an investor have expected if they applied this strategy to their portfolio over the years?
Stovall: By owning in equal proportions those 10 industries that were the best performers in the trailing 12 months going back to 1991—since the first sub-industries were first introduced in 1990—an investor would have outperformed the S&P 500 by more than 5.5% in each and every year. The strategy produced a compound annual growth rate of 15.2% versus the S&P 500’s 9.5% during that time.
You would have also outperformed the market two out of every three years, so not only was the compound rate of growth very impressive, but the frequency of beating the market continued to be encouraging.
EQ: Since there are no ETFs for all of the S&P 500’s sub-industries, how can investors apply this strategy to their portfolios?
Stovall: You can find 40 sector and sub-industry ETFs at www.SPDRS.com, but unfortunately you don’t have all 130 sub-industries available in ETF form. So I recommend investors take a look at a single stock to serve as a proxy for each of those sub-industries. So while the ETF community is beginning to build out their representation of S&P 500 sub-industries, we’re only about a third of the way there.
EQ: What are some concerns that investors need to be aware of when using individual stocks as a proxy for an industry group or sector?
Stovall: Investors should realize that by using the one-stock proxies for a multiple-stock sub-industry, you don’t get the diversification that a sub-industry provides. In a sense, you could end up just by shear bad luck picking that one stock that did not do very well going forward.
Some investors pick the largest stock within the sub-industry index, while otherspick the stock that has the highest momentum. What I try to do is look to those stocks that have the highest investment recommendation by S&P equity analysts. But there’s still no sure-fire way to guarantee that you get a return that mimics that for the overall sub-industry.
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