When a stock makes a big advance or suffers a harsh decline, most people tend to blame or credit the move on one of two factors: the general market or the quality of individual company.
Often, this reasoning holds true. The vast majority of the great stock advances belonged to shares in companies with rapid earnings and sales growth. But even shares in superb companies tend to fall in bear markets. And while the stocks of corporate leaders benefit most in bull markets, a good bull can lift the shares of laggard companies as well.
Since the 1960s, a third major factor has come into view, thanks to the use of computers and modern statistics to zero in on what really moves a stock’s price. Whether you trade or invest, pick individual stocks or use stock funds, you shouldn’t ignore this powerful force in your moneymaking strategy.
Industrial sectors represent this third ingredient that can either supercharge your portfolio or turn it into a laggard or loser.
The gulf in performance from stocks in one sector to the next can be extreme. Consider a few statistics from 1999.
The S&P 500 gained 19.5% over the same time frame. A respectable showing, but dwarfed by the 86.5% return by the Nasdaq Composite. The divergence clearly is explained by looking at dominance of technology stocks in the Nasdaq. The S&P 500 far better represents the overall composition of U.S. industry.
Dig deeper, and you’ll see that it wasn’t just technology that won the year, but rather key sectors and categories within that arena. The Nasdaq’s charge was led by its biggest companies. The Nasdaq 100 Index rose 102% in 1999. The Philadelphia Semiconductor Index notched a 101% return in 1999. The AMEX Biotechnology Index surged 111%. The CBOE Computer Software Index vaulted 117%. The AMEX Telecommunications Index gained 74%.
And, of course, there were the Internet stocks. The Inter@ctive Week Internet Index soared 168% in 1999.
Invest in the wrong sector, and you’re likely to come out a laggard or a loser. Even if a company can manage to overcome the economic conditions troubling its sector, its stock still may language as cash flows into good companies that have the added glamour of belonging to a hot sector.
Consider the the Morgan Stanley Cyclical Index, which has a smattering of tech but is heavily weighted toward old-economy manufacturers, metals, papers, chemicals and transports. The cyclical index rose 23% in 1999. Banks and other financials had a dismal year. The S&P 40 Financials Index slid 22%.
These divergences are not unusual. They are the norm. In other years, different sectors gain the upper hand, while others languish.
The implications for investors and traders are obvious. By zeroing in on the best sectors, the stock picker increases the odds that the companies he selects will reward him with share-price gains.
Meanwhile, the active fund investor and the fund trader can latch onto the sector as a whole, focusing part of their capital into sector funds that are in strong uptrends. The reason for this has to do with a concept called relative strength. Contrary to the view that what goes up must come down, the odds are more likely that stocks and sectors in strong uptrends tend to keep outperforming. Stocks and sectors in downtrends are the most likely candidates to turn out losers or laggards in the future.
A great variety of vehicles exist for those who use funds to exploit market moves. Long-term investors, intermediate term traders and short-term traders can choose both mutual funds and their increasingly popular cousins, exchange-traded funds. Within each class, you will find funds focused on specific sectors.
For example, you could have banked on the Nasdaq 100 by buying “cubes,” shares of the Nasdaq-100 Index Tracking Stock (QQQ), an exchange-traded fund listed on the American Stock Exchange. This would be the preferred option for the fund trader or active investor who wanted to trade “at the market” vs. waiting for the day’s closing price. If mutual funds are your preferred vehicle, and you are willing to buy shares based on the day’s closing price, then you could buy shares in a mutual fund indexed to the Nasdaq 100. One sample would be the Rydex OTC Fund (RYOCX).
Or say you choose to aim at a specific sector or industry group. Let’s say you notice a great deal of strength among technology funds in top relative strength lists.
The mutual fund investor could go long by buy shares in one of the best-performing tech funds, say. Invesco Sector Funds’ Technology fund (FTCHX) or Scudder Technology (SCUTX) or Dreyfus Premier Technology Growth (DTGRX).
The ETF trader or active investor might notice corresponding strength in Technology Sector (XLK) shares. A trader or active investor might “drill down” even deeper to find an even hotter subsector or industry group and snap up shares in, for instance, one of the Holding Company Depositary Receipts, or HOLDRs, a class of exchange-traded funds created by Merrill Lynch. For instance, one might buy shares in the B2B Internet (BHH) HOLDRs or the Telecom (TTH) HOLDRs.