Lessons From 2007: A Baker's Dozen

2) Buy sector strength (and avoid sector weakness): It's a truism of real estate: It's better to own a lousy house in a great neighborhood than a great house in a lousy one. And the same is true for stock sectors: Buying mediocre companies in great sectors generated positive results, while great companies in poor sectors struggled.

The losers are obvious: The homebuilders, financials, monoline insurers and retailers all struggled this year. The winners? Anything related to agriculture, solar energy, oil servicing, industrials, software, exporters, infrastructure plays -- even asset-gatherers thrived. Stocks in these groups consistently showed up in the 52-week-high list.

Goldman Sachs (GS - commentary - Cramer's Take) is a perfect example. Despite record revenue and earnings in 2007, the stock was up less than 15% in 2007. In 2006, on much weaker revenue and profits, shares climbed more than 50%. Great house, bad neighborhood.

3) Never blindly follow the "big money": Why? Because professionals make dumb mistakes too. 2007 saw a number of surprise investments where so-called smart money bought big chunks of troubled companies -- Bank of America (BAC - commentary - Cramer's Take) buying a chunk of Countrywide (CFC - commentary - Cramer's Take) being Exhibit A. Many people chased the so-called smart money into these trades. Unfortunately, all of these trades have proven to be jumbo losers. If this keeps up, the "smart money" may need to start looking for a new nickname.

4) Day-to-day stock action is mostly noise: This is blasphemy to some people, but it's true: Markets eventually get pricing right. But the key to understanding this is the word "eventually." Over the shorter term, markets frequently under- or overprice a stock before settling into the right approximation of value. This process typically occurs over broad lengths of time. Unfortunately, that doesn't stop some rather suspect interpretations of what these short-term movements mean. I look at these tea readings as Rorschach tests, revealing more about the speaker than they do about the subject.

Case in point: The homebuilders. It seemed that every time there was even the slightest uptick in the group, some bozo would declare that the bottom of the real estate cycle was in. Indeed, every dead-cat bounce or short squeeze was trotted out as proof positive that the housing problem was over. Only it wasn't, and the homebuilders cratered some 70% off their highs. You don't need to be a technician to know this: The little squiggles on the chart mean a whole lot less than the big squiggles do.

5) P/E matters less than you think: One of the things I heard a lot this year was "I (dis)like this stock because it has a (high)low P/E. News flash: P/E ratios alone tell you very little about a stock's future prospects.

If that sounds like blasphemy, please look at a few examples: Google (GOOG - commentary - Cramer's Take), Apple (AAPL - commentary - Cramer's Take) and Mosaic (MOS - commentary - Cramer's Take) all sported high P/Es at the beginning of the year. Their stocks have done splendidly. On the other hand, back in January, retailers, financials and homebuilders all had reasonably cheap P/Es. (How'd they do?)

It helps if you think of P/Es not as a photo but as video. The direction matters more than the mere number: Were P/Es likely to come down as sales ramped up? Or were P/Es modest because they were at the top of a profit cycle, and were likely to fall? The answer to these questions explains the difference between the winners and losers, and that leads us to:

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At the time of publication, Ritholtz had no positions in stocks mentioned, although holdings can change at any time. Barry Ritholtz is the chief market strategist for Ritholtz Research, an independent institutional research firm, specializing in the analysis of macroeconomic trends and the capital markets. The firm's variant perspectives are applied to the fixed income, equity and commodity markets, both domestically and internationally. Other areas of research coverage also include consumer, real estate, geopolitics, technology and digital media. Ritholtz is also president of Ritholtz Capital Partners (RCP), a New York based hedge fund. RCP is driven by the analysis performed by Ritholtz Research. Ritholtz appreciates your feedback; click here to send him an email.