One common move among investors is to buy the worst performing asset class, sector or fund of the past year, with the idea that markets go in cycles and what has fallen so low will have plenty of room to rise. It may be common, but it's a mistake. One year is too short a period for any sort of mean reversion to take effect, says The Leuthold Group, in its January research report.
Rather, Leuthold finds that investing in the second-best performing asset class or sector—the bridesmaid, so to speak—of the previous year is the optimal price-based strategy, and it has been over the last 40 years.
Taking this approach, investors should buy the MSCI EAFE in 2013, which returned 17.9 percent in 2012, just behind the NAREIT Index's 20.1%. Looking at the sector's of the S&P, it is consumer discretionary stocks that should be headed to the altar this year, with a runner-up total return of 24.1% in 2012 just behind the 28.8% returned by 2012's darling, financial stocks.
Investing in the previous year’s second-best-performing asset class has yielded an annualized return of 15.6% since 1973, compared to 7.6% for the worst performing asset class and 10% for the S&P 500 index over that time period. If one invested in the best-performing asset class of the previous year every year since 1973, they would see an annualized return of 14%.
“Things surprisingly tend to stay the same,” said Doug Ramsey, chief investment officer of Leuthold Weeden Capital Management.
Meanwhile, investing in last year’s second-best sector within the S&P 500 has returned an annualized 13.3% since 1991, compared to 9.1% for the S&P 500 index over that period. The strategy outperformed the S&P 500 in 13 of the last 22 years.
People often believe that economic cycles reflect market cycles, but market cycles are "more mature" than economic cycles, Ramsey said. “Market tops are a very broad, elongated process.”
Of course, the strategy is not bulletproof, Leuthold admitted. 2011’s bridesmaid—gold—was only the fifth best performing asset class of 2012, returning 5.9% last year.
But Ramsey likes this year’s pick—EAFE stocks—for its attractive valuation. Measured by the MSCI EAFE index, it’s currently trading at 13 times earnings.
Todd Rosenbluth, analyst with S&P Capital IQ, believes that while the once-a-bridesmaid-soon-to-be-a-bride strategy is an interesting one, it’s better for investors to look at the fundamentals of any given asset class, sector or individual stock. And every year is potentially different, he said.
“Investors should not blindly choose the top or the second or the bottom performer and invest in that just because of how it performed last year,” Rosenbluth said. “What worked in one year isn’t necessarily going to work in the next year.”
S&P Capital IQ analysts have a positive outlook on consumer discretionary stocks, but the outlook is not based solely on how the sector performed last year, Rosenbluth said. They believe these stocks have strong fundamentals and are undervalued. Consumer discretionary stocks have a price to earnings ratio of 15, compared to 13 for the S&P 500. But Rosenbluth expects higher earnings growth from consumer discretionary than from the index overall.
While Leuthold’s strategy has worked in the past, there’s no guarantee that it will continue into the future, said Mel Lindauer, co-author of The Bogleheads' Guide to Investing and The Bogleheads' Guide to Retirement Planning.
“My reaction is that you can always torture the data 'til it confesses,” Lindauer said. “These kinds of things work until they suddenly stop working, and that could well be immediately after everyone jumps in after reading this data.”