This column was originally published on RealMoney on Oct. 26 at 9:47 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.Because my market bias has changed from bearish to bullish over the past couple of weeks, I wanted to get a feel for what sectors could outperform the market in the current conditions. That seems like a tall order -- after all, isn't that what every long-side investor wants to know? But I believe that using one key measure and a good selection of exchange-traded funds to represent the market will yield the sectors that will prove to be good bets in an up market. Considering the comparative relative strength of 14 ETFs in some carefully selected trading systems leads me to believe that biotech, broadband, Internet and oil service stocks should be winners. Let me explain how I arrived at that conclusion.
The Key ConceptComparative relative strength is determined by comparing an equity's price either to its historical prices or another data series. For example, comparing the price of an equity to a popular index, such as the S&P 500, is a form of measuring the equity's relative strength. Relative strength is just a method of identifying strong sectors or stocks. Not a new concept, its utility as a stock selection tool has been explored and validated in academic and trading journals going back to the 1960s. The basic idea behind its use is that the strong -- current outperformers -- get stronger, regardless of the market environment. In up markets, the strongest equities should outperform, and in down markets, they should underperform to a lesser degree than the general market. Comparative relative strength has been used in market-timing models, with varying degrees of success. Most models involve rebalancing the portfolio at some predetermined interval, say, every month or every six months, so that it always holds the strongest-performing sectors or stocks.
The MethodologyAgain, the recent shift in my market bias from bearish to bullish has me interested in finding those areas of the market that are poised to outperform. I chose to consider how 14 exchange-traded funds have performed during periods of bullish bias. I worked with these 14 ETFs because they represent most of the major segments of the equities market.
- Biotech HOLDRs ( BBH) Broadband HOLDRs ( BDH) Internet HOLDRs ( HHH) Oil Service HOLDRs ( OIH) Pharmaceutical HOLDRs ( PPH) Regional Bank HOLDRs ( RKH) Retail HOLDRs ( RTH) Semiconductor HOLDRs ( SMH) Software HOLDRs ( SWH) Utilities HOLDRs ( UTH) Wireless HOLDRs ( WMH) Energy Select SPDRs ( XLE) Health Care Select SPDRs ( XLV) Industrial Select SPDRs ( XLI)
The ResultsBefore we get to the analysis of how the relative-strength market-timing strategy performed, we should examine how the stock-timing model performed over the past five years, because it's the filter that overlays the strategy. If you had bought the Nasdaq market only when the market bias was bullish, your capital would have compounded at a 16.75% annual rate. To achieve these returns, you would have had to suffer through two drawdown periods in which you lost 20% (2001) and 30% (2002) of your capital. As is well known, the Nasdaq has lost about 50% of its value since July 2000. But if instead of buying the market you had bought the four sectors with the highest relative strength when the market bias changed from bearish to bullish since July 2000, your capital would have compounded at an 11% annual rate. Under this strategy, one drawdown period would have resulted in a loss of 25% of your capital (2002) and another that would've given a loss of 15% of your capital (2001). Compared to just buying the Nasdaq outright, buying the four strongest relative-strength performers did not improve reward relative to the risk. In other words, with the relative-strength strategy, the reward and the risk both decreased. I was hoping to see returns increase while risk decreased. This did not happen.
The WinnersAlthough the data are limited, buying the highest relative-strength exchange-traded fund did outperform a strategy of buying the losing sectors. Strength does beget strength, and concentrating your efforts in the strongest sectors is a winning strategy. However, this strategy did not outperform a basic market-timing strategy, because a market-timing strategy based on the speculative Nasdaq is highly concentrated. Risk and, consequently, reward are likely to be higher as opposed to a strategy spread out across different sectors. Buying out-of-favor sectors at a time of market bullishness leads to underperformance and excessive drawdowns. This is very clear from the data. The current leading ETFs (from weakest to strongest) are Internet HOLDRs, Biotech HOLDRs, Broadband HOLDRs and Oil Service HOLDRs. Focusing your efforts in the sectors these ETFs represent -- or even just buying these ETFs outright -- should prove to be a winning strategy during the up market period that I believe is starting now.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Broadband HOLDRs, Internet HOLDRs, Regional Bank HOLDRs, Retail HOLDRs, Software HOLDRs and Wireless HOLDRs to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices. P.S. from TheStreet.com Editor-in-Chief, Dave Morrow:
It's always been my opinion that it pays to have more -- not fewer -- expert market views and analyses when you're making investing or trading decisions. That's why I recommend you take advantage of our free trial offer to TheStreet.com RealMoney premium Web site, where you'll get in-depth commentary and money-making strategies from over 50 Wall Street pros, including Jim Cramer. Take my advice -- try it now.