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Get Four
|  | DECEMBER 15, 2004
 SAM STOVALL'S SECTOR WATCH By Sam Stovall Investing: Less Guts, More Glory By blending the volatile technology sector with areas of low correlation, investors can reap even higher gains with lower risk Pity the poor tech investor. During the past 15 years, someone who invested in the S&P 500 Information Technology index would have experienced price volatility that was more than twice that of the S&P 500 index itself. But don't feel too sorry for them. As can be seen in the graph below, they also experienced a compound annual return that was about 35% higher than that of the broader benchmark. And as most investors know, to achieve high returns, one has to take on a greater amount of risk. This risk is usually defined as the standard deviation of annual returns. In this case, since 1990, two out of every three years the tech investor saw his or her investment appreciate by 11.4%, give or take 35.3%. In reality, returns ranged between +78.4% and -40%. No wonder some investors say a pictorial representation of this volatility would look more like an EKG diagram. 
INTUITIVE PAIRING. To help decide if the extra return is worth the additional risk taken, some investors divide the annual return by the standard deviation to arrive at a risk-adjusted return (the higher the outcome, the better). In this case, the S&P 500 investor received a better risk-adjusted return (8.4/17.4 = 0.40) than did the tech sector investor (11.3/35.4 = 0.32). Yet informed investors also know that a portfolio of assets that aren't correlated -- or show a very low degree of correlation -- can improve this risk-adjusted return tradeoff. Such a strategy can help to smooth out the variability of returns in the short term. So which S&P 500 sector showed the lowest correlation with the S&P 500 Information Technology Index? It's almost intuitive: The classic defensive group, Consumer Staples. The table below shows the correlation coefficient of the rolling 12-month price changes for each S&P sector vs. the other sectors since 1990 -- which is as far back as S&P sector indexes go. (Note that +1 represents perfect positive correlation, 0 shows no correlation, and -1 demonstrates perfect negative correlation). The lowest correlations by sector (read from top to bottom) are in bold.
NEARLY A FREE LUNCH. The 0.11 correlation that Information Technology registered with Consumer Staples was the lowest, while the 0.7 correlation with Telecommunications Services was the highest. We also find it interesting is that Consumer Staples had the lowest correlation with five sectors -- the most of any -- and just barely lost out to Materials for the lowest vs. the S&P 500. So what should an investor take away from this analysis? Should history repeat itself -- and there's no guarantee that it will -- the bar chart above shows that from Dec. 31, 1990, through Dec. 10, 2004, an investor who had a portfolio consisting of 50% Information Technology and 50% Consumer Staples (rebalanced annually) would have received a higher return, a lower standard deviation, and better risk-adjusted gains then if he or she had invested in Information Technology alone (11.8/20.2=0.58). What's more, this combination's return and risk-adjusted return exceeded that for the S&P 500 index. Other sector combinations also produced higher risk-adjusted returns than the S&P 500. And an investor can't ask for much more than that. While it may not be the equivalent of a free lunch on Wall Street, it's pretty darn close. Industry Momentum List Update For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) and their proxies (the highest STARS-ranked companies in the subindustry index; tie goes to the largest market value) as of Dec. 10, 2004:
Required Disclosures 5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis. 4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis. 3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis. 2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain. 1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis. As of Sept. 30, 2004, SPIAS and their U.S. research analysts have recommended 29.2% of issuers with buy recommendations, 58.5% with hold recommendations and 12.3% with sell recommendations. All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041. Other Disclosures This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS. Disclaimers This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.  Stovall is chief investment strategist for Standard & Poor's All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc. Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | |
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