Since the market bottomed out just over a year ago, some strong sector themes have established themselves. Backing a so called dog strategy of investing in the losers has delivered especially strong returns and small caps have outgunned their larger peers. However, history suggests these recently established themes are more likely to reverse than to repeat during the coming year, if the recovery persists.
Betting on the bear market's worst performing sectors has been an excellent strategy recently. Four of the 10 best performing sectors during the year to March 2010 were among the 10 worst performers during the bear market. And nine out of the 10 worst performing sectors during the bear market comfortably beat the median sector performance during the first year of recovery.
Meanwhile, a conventional momentum strategy of backing bear market winners failed to deliver. Only one sector -- industrial metals -- produced a top 10 performance during both the bear market and the first year of the recovery. And half of the bear market's 10 best performing sectors were to be found among the 10 worst performers during the first recovery year.
The idea of investing in 'dogs' seems to have grown in popularity since Michael O'Higgins introduced the 'Dogs of the Dow' strategy in the early 1990s in a book he wrote. His advice was strictly addressed to the 30 stocks that make up the Dow Jones Industrial Average, and because of this there is an underlying quality to the stocks that he was putting forward. The way his plan worked was to pick the 10 stocks that were giving the best dividend yield, that is the dividend divided by the stock price, and to put equal funds in each.
This was originally put forward as a strategy to rebalance a portfolio once a year -- or possibly a year and a day, to make sure that any gains were treated as long-term capital gains. It's easy to see why it should work, as you are investing in large company stocks that have a high yield because their prices are depressed. The figures show that in the last 17 years, this strategy would have outperformed the DJIA convincingly in 15 of them.
Even with the large cap stocks that comprise the DJIA, there are critics who maintain that the "dogs" strategy is flawed, doesn't take account of transaction costs, and can be beaten by buy-and-hold only strategies. It's plain to see that the “dogs” strategy relies on stock market cycles to be effective. The reason that it may work is that beaten down stocks and sectors can recover cyclically to a realistic valuation.
If you choose to back the best performing sectors in the bear market for a momentum strategy, you should be prepared to be disappointed. Those sectors that have held up during bad times don't have anywhere to go when times improve, whereas the ones that suffered, provided they can hang together, have given themselves tremendous scope and space for betterment when the good times return.
The alternative of adopting a dog strategy, provided it is entered with a clear understanding of why it has performed in the past and may perform again, is certainly one that should be considered. Dogs can remain dogs for a time, so timing your trade is important, particularly if you are using contracts for difference to add leverage to your transaction, because of the ongoing interest charges that they carry. But if you shortlist appropriate candidates and watch for any signs of life, then you should be able to benefit from this approach.