April 14th, 2008

Industry Group Does Matter: Which Ones Will Lead?

Even though my previously described Market Timing Indicator dictates that being in the market is still too risky, much riskier than any possible reward might warrant, it’s not too early to start thinking about the performance of the various industry groups. If our goals are 1) beating the market averages and 2) regardless of the market, never end a year with a portfolio loss, then we need to be selective in the industry groups in which our money will be invested.

I prefer using the IBD Industry Groups since they continually serially rank the performance of all their groups, the Hemscott Industry Group designations are the ones used by Yahoo! Finance and my charting software, Worden Bros. Telechart 2007. They categorize the over 6500 stocks charts into 208 Industry Groups; data for most of the groups begin in 1988. As an example, here’s a chart of the Chemicals-Major Diversified Industry Group:

Currently, nine stocks comprise this Industry Group, including: APD, ASH, CE, DOW, EMN, FMC, ROH, SHW. However, two of the group (two of the nine, EMN and CE) only started trading in 1994 and 2005, respectively. I’m not sure how Hemscott calculates their composite index and how they handle any group where members are dropped for some reason. But let’s still assume that it’s representative.

On the surface, it doesn’t look all that bad. The group’s index, as depicted in the above chart, is 454% of the average when it began in 1998. But how does that stack up against the overall market? I constructed an RSI (ratio of the Group Index/S&P 500 Index) over the same period and added 300-day and 180-day moving averages. The chart is revealing:

Stocks in the Industry Group lagged significantly behind the rest of the market during the Tech Bubble ’90s and only since the crash began to play catch up with the average stock still 75% of the average S&P 500 stock.

When you talk about averages like the S&P 500, by definition about half the stocks in that universe will perform worse than the average and the other half better. In order to consistent beat the average, you must have the major portion of your portfolio in the industry groups that are leading the average.

There was an excellent article in Sunday’s NY Times Business Section by Mark Hulbert entitled “Picking the Forest or the Trees” saying that the

“ability to find top-performing industries is a crucial factor in determining mutual funds that are likely to perform best in the future. In fact, according to a new study, a manager’s success in emphasizing sectors in a portfolio is a far better forecaster of performance than his ability to pick individual stocks.”

The bottom line question is which “which Industry Groups will be the leaders coming out of this current credit crises/recession driven bear market?” More on that later.

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