Thursday, January 05, 2006

The end justifies the means?

Following up on the post about Sam Stovall and investing in the prior year's best sector, here is an article from Mr. Stovall explaining Standard & Poor's research on this topic.

Businessweek: Go for Momentum or Recovery?

A couple of notes: The article discusses investing in the top 10 sectors versus the bottom 10 sectors, rather than just the top sector, which is what I have examined [hey, I've got limited resources..]. Using historical data, the results are that over the time period studied, investing in the top 10 sectors led to almost twice the return of the S&P500, while also increasing the risk adjusted return, which is basically investment nirvana. [And before you go crazy with this, remember it is historical data and backtesting. But you are betting on the strongest horses, and they have a tendency to keep their strength for a while.]

I found similar results when looking at just the top performing sector. Well, mostly. But picking one versus ten leads to much more volatility, and the occasional train wreck when a high flying sector craters. Caveat emptor.

Looking at S&P's list of 2005's best performing sectors, 4 of the 10 are energy related, which seems to bode well for the energy sector in 2006, according to this study.

Here's the problem though: Two of those energy sectors were also top performers in 2004, so they are now on a multi-year winning streak. And they not only outperformed, they hot dogged it. So it is time for caution, folks.

I have another way of slicing the sector data that I haven't had a chance to look at yet. If it gives a strong signal on something, I'll probably mention it later.