Using Industry Rotation to Gain an Edge, Maybe

by: David Merkel, CFA

For the last year and three months I have written a weekly piece on industry rotation that is largely based on price momentum, and described in this old piece that I wrote: A Different Look at Industry Momentum. I have my doubts about that piece around turning points and in choppy markets. I stated as much in my later piece A Different Look at Industry Momentum — II. It seems that the momentum effect has been declining over time.

In the near future I hope to do an update for both pieces, which will show whether I have been wrong in the short run. Unfortunately, since the original piece, I have been through a hard disk crash, so I will be rebuilding from scratch.

All that said, here are the industries with strong momentum (new industries in italics; as for the particular companies mentioned here, these are promising candidates for further due diligence):

  • Catalogue Retailers – HSNI
  • Broadcasting & Cable TV – CBS
  • Household Appliances – WHR
  • Residential REITs – AIV, UDR
  • Real Estate Services – JLL
  • Internet Retail – NFLX
  • Auto Manufacturers – F
  • Computer Storage & Peripherals – SNDK, LXK, NTAP
  • Hotels – HOT
  • Airlines – ALK
  • Multiline Insurance – AIG, GNW
  • Leisure Products – BC, ACAT
  • Health Care Technology – CERN
  • Commercial Printing – CGX
  • Apparel Retail – LTD, BWS, FINL, ANN, ZUMZ, DBRN
  • Health Care Distributors – ABC, CAH
  • Apparel & Accessories – PERY, ZQK, MFB, LIZ
  • Cable & Satellite – TWC
  • Gold & Precious Metals Miners – NEM
  • Footwear – SKX, CROX
  • Consumer Finance – EZPW, WRLD
  • Info Tech Consulting – ACXM, CTSH, IT
  • Real Estate Development – FOR
  • Home Furnishings – WSM
  • Photographic Products – EK
  • General Merchandising – BIG
  • Movies & Entertainment – LYV
  • Retail REITs – PEI, MAC, KRG
  • Office REITs – SLG, ARE

And here are the weak industries:

  • Oil & Gas Refining & Marketing
  • Semiconductor Equipment
  • Building Products
  • Industrial Gases
  • Communications Equipment
  • Construction Materials
  • Education Services
  • Homebuilding
  • Human Resources & Employment Services
  • Brewers
  • Integrated Oil & Gas
  • Oil & Gas Drilling
  • Electric Utilities
  • Water Utilities
  • Integrated Telecommunication Services
  • Reinsurance
  • Diversified Support Service
  • Asset Management & Custody Banks
  • Heavy Electrical Equipment (NYSE:AZZ)
  • Agricultural Products
  • Independent Power Production
  • Construction and Engineering
  • Investment Banking & Brokerage
  • Biotech
  • Aluminum
  • Diversified (Leucadia (NYSE:LUK))
  • Home Entertainment Software
  • Fertilizers & Agricultural Chemicals
  • Tire & Rubber (Goodyear (NYSE:GT))
  • Alternative Carriers

I am less than a momentum player, even though I know it works generally. At turning points, models like these do not work well. That has been my worry since I began writing a weekly industry rotation report for my employer in March of 2009. Though momentum works enough of the the time that it overcomes the turning points in the long run, when the market is volatile, choppy, etc., using momentum seems to be a fool’s errand. Industry momentum trends usually last for years, but what if they only last for months?

That is what makes analysis of price trends in the market difficult. There is not a consistent periodicity to market cycles. I might argue that bull markets tend to correspond to long cycles, and bear markets to short/nonexistent cycles. So, maybe the answer stares me in the face — though I have a variety of models for industry rotation, I use them as guides, not rules. When I am more concerned that short term performance may not persist, I pick from the bottom of the list rather than the top, seeking mean reversion. When I don’t see headwinds for the economy as a whole, I pick more from the top of the list.

But, I like picking from both ends of the list, because the top end makes me ask the question: “have people underestimated this?” The bottom of the list makes me ask: “is there are great big sign over the industry that reads, ‘Abandon all hope, all ye who enter here.’ ?” Both conditions offer opportunities for profit.

And, given the preponderance of top-down players out there who hug the indexes (much institutional money), and my friends who are bottom-up stock pickers (but still glance at the indexes and adjust), it leaves room for those of us who are willing to express distinct views regarding industries. For me today, it is fourfold:

  • If you are going to buy cyclicality, you may as well own energy names. Energy drives the economy, and they aren’t making any more of it. (Unless we get higher efficiency means of converting solar, wind, or tides.)
  • Insurers are relatively safe from an asset standpoint and undervalued.
  • Utilities throw off relatively safe cash flows in a bad environment.
  • Well-financed companies that are needed regardless of the cycle, and are cheap-ish.

If you have been reading me for any significant length of time, you know that I eschew simple answers. Life, and investment performance, are complex beasts. My view of the markets at present is mixed; there are reasons for optimism, and reasons for fear. Typically, I don’t give into fear in full, rather than leave the markets, I take a more conservative position within them.

And, I don’t let inflation fears scare me out of the markets. Equity markets don’t respond to inflation that much. Scarcity of capital, or high real interest rates are another matter — at that point, far better to hold money market funds, gold, etc., though energy stocks should work there as well, and utilities will be middling.

Depression would be another matter, but I see our politicians fighting depression as they see it, leading to a Japan-style economy, where there is no bad asset that can’t be financed through the monetary base at 0%. (They are willing to inflate assets, but not goods prices.) That is, if they can avoid a full-scale run on the currency, such as may be beginning to happen with the Euro now. (What taxation authority stands behind the euro? Please ask Mr. Sarkozy or Ms. Merkel, though I think you will get different versions of obfuscation out of each.)

I am working to preserve capital now, and year-to-date in 2010 I am down a little less than a percent. Though Value Line recently got a little more bullish, I am waiting to get more bullish. I will add little bit by little bit to my positions as they go down, but I see no reason to add dramatically today.

So, be wary as always, and conservative in your decisions. Better to avoid errors than to hit home runs in this environment.