May 12th, 2011

Sell Rule: Out-of-Favor Industry Groups

A mistake most traders, including myself, often make is focusing too much on what is or, more correctly, what will in the near future be moving higher. In the Weekly Recap Report I send to subscribers, I include both an breakdown by industry group of stocks in the current Portfolio as well as a list of Investors’ Business Daily’s top-ranked Industry groups and Groups moving up in rank the most during the past 3 months.

Our goal is finding tomorrow’s hot stocks. At the same time, however, we should make sure that the stocks we already have in our portfolios continue performing. It’s just as important to see what Industry Groups are falling the most in their rankings as it is those that are rising the fastest.

For example, I’ve been beating the drum for healthcare related Industry Groups for some months and, as of this past weekend, over 20% of the portfolio is now made up by stocks in those groups; most have performed extremely well. I included the following chart in a recent Recap Report of the Medical-Biomed/Biotech ranking showing that these stocks, as a group, have been among the best performers for over a year (click on images to enlarge):

What I hadn’t looked at or acted on was the other end of the spectrum – the industry groups that might have been falling fastest. If I had, I would have seen, for example, was that all the Oil & Gas related Industry Groups had begun losing their top rank positions. I had blinders on but if I had looked at the other end, I would have seen the stocks that were dropping the most in ranking. I would have seen groups like the Oil & Gas-International Exploration and Development:

and the Oil & Gas – Canadian Exploration and Development:

Both of these groups had started turning down from their top rankings in mid-March and were now among the lower half in ranking of the 197 Industry Groups; both were now clearly under the 20-week moving average of their ranking. If I had taken notice and acted as quickly to dispose of these stocks in the Portfolio as I was adding healthcare stocks then I would have preserved a lot of profit.

Last November, I wrote “My Sell Rules Discipline” in which one rule is selling “individual stocks where risks associated with that stock appear to have increased”; the fourth example is “an industry group if it falls out of favor”. I just didn’t follow my own rules. I have long known that Industry Group factors contribute about 30% to a stock’s movement (the market is 50% and factors related exclusively to the individual stock contribute the remaining 20%). What I just now re-learned, a lesson I won’t soon forget, is that we have to look not only for new stocks to add but also to find and quickly act to prune out stocks in Industry Groups out of which money clearly is flowing.

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