Momentum's Winning Force


By Sam Stovall One question I get annually: Is it better to invest in last year's worst performing industries (hoping for a rebound) or in the best performers (betting on the continuation of strong momentum)?

It's a bit like the fantasy baseball aficionado's early-season dilemma: Choose the player who had the hot hand last season, in hopes he will stay that way -- or the one who fell into a slump and is due for a comeback?

While both techniques offer a better compound annual return since 1991 than investing in the Standard & Poor's 500 stock index as a whole, sticking with the winners has provided the superior gain and risk-adjusted return (return divided by

volatility, where a higher number is preferred), along with a higher frequency of annual market outperformance. Of course, past performance is no guarantee of future results.

Investing in the best and Worst S&P 500 Industries from the Prior Year: 1991-2004

Compound Annual Return

Standard Deviation

Risk-Adj. Return

Freq. of Outperf.

Best 10

18.4%

26%

0.70

79%

Worst 10

13.8%

25%

0.56

57%

S&P 500

9.7%

17%

0.56

NA

Since there are very few industry-level ETFs (exchange-traded funds), one way to invest in either of these styles is to select the largest company in each market-cap weighted S&P subindustry index to serve as the industry proxy.

Another way would be to add a bit of analytical value by selecting the subindustry index component company with the highest S&P STARS ranking, as I have done in the table below.

Using this technique, based on 2004 subindustry index performances (without dividends), the best and worst portfolios for 2005 would look like the following (with the S&P 500 as the dividing line between last year's winners and losers):

S&P Subindustry Index

% Chg.

Top STARS Co.

Ticker

STARS

Price

Fertilizers & Agricultural Chemicals

93.0

Monsanto

MON

2

$56

Internet Retail

80.0

eBay

EBAY

3

$116

Internet Software & Services

66.8

Yahoo!

YHOO

4

$38

Oil & Gas Refining, Mktg., Trans.

61.5

Valero Energy

VLO

4

$45

Steel

58.1

Nucor

NUE

3

$52

Wireless Telecommunication Services

57.3

Nextel Comm.

NXTL

4

$30

Managed Health Care

52.7

WellPoint

WLP

5

$115

Agricultural Products

46.6

Archer-Daniels-Midland

ADM

3

$22

Oil & Gas Drilling

45.1

Nabors Indus.

NBR

5

$51

Hotels, Resorts & Cruise Lines

44.1

Carnival

CCL

4

$58

S&P 500

9.0

NA

NA

NA

NA

Broadcasting & Cable TV

(9.1)

Univision

UVN

4

$29

Pharmaceuticals

(9.5)

Johnson & Johnson

JNJ

4

$63

Health Care Facilities

(10.9)

Manor Care

HCR

4

$35

Automobile Manufacturers

(16.9)

Ford

F

3

$15

Electronic Manufacturing Services

(17.0)

Sanmina-SCI

SANM

5

$8

Aluminum

(17.3)

Alcoa

AA

4

$31

Semiconductors

(21.3)

Maxim Integrated

MXIM

5

$42

Insurance Brokers

(24.2)

Marsh & McLennan

MMC

3

$33

Semiconductor Equipment

(25.0)

Applied Materials

AMAT

4

$17

IT Consulting & Other Services

(31.4)

Unisys

UIS

2

$10

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), along with their proxies (the highest STARS-ranked companies in the sub-industry index -- tie goes to the largest market value) as of Dec. 31, 2004.

Industry

Company

Ticker

STARS Rank

Recent Price

Agricultural Products

Archer-Daniels-Midland

ADM

3

$22

Commodity Chemicals

Lyondell Chemical

LYO

3

$29

Consumer Electronics

Harman Intl.

HAR

3

$127

Fertilizers & Agricultural Chemicals

Scotts Co.

SMG

4

$74

Hotels, Resorts & Cruise Lines

Carnival

CCL

4

$58

Internet Retail

eBay

`EBAY

3

$116

Internet Software & Services

Yahoo!

YHOO

4

$38

Managed Health Care

PacifiCare

PHS

5

$57

Multi-Sector Holdings

Leucadia Natl.

LUK

NR

$69

Oil & Gas Refining, Mktg., Trans.

Valero Energy

VLO

4

$45

Steel

Nucor

NUE

3

$52

Wireless Telecom Svcs.

Nextel Partners

NXTP

4

$20

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 September 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


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