Saturday, March 5, 2016

When laggards become leaders

One of my favorite times to buy stocks is when a sector that has lagged the broad stock market for a while ("the lagging sector") begins to outperform it.

Specifically, I look for situations in which 1) the lagging sector has underperformed the broad market for more than a year, 2) the stocks in the lagging sector have lost most of their value from their all-time highs, 3) the broad market has begun to fall, and the lagging sector is important enough that investors associate the broad market's turmoil with the sector's problems, and 4) finally, the lagging sector flattens or begins to rise while the broad market continues falling.

In my experience, this pattern often leads to the lagging sector outperforming the broad market while both rise significantly. The lagging sector's outperformance indicates that its trading dynamics have improved, while its prior underperformance gives it the potential to continue rising.

Below are two notable examples with charts.

1998: Korean stocks
From June 1997 to June 1998, the Asian Financial Crisis caused Korea's KOSPI stock index to lose 70% of its value. The Korean won collapsed simultaneously, so the KOSPI's dollar-denominated loss was even larger. During the same period, the S&P 500 rose 25%.

The KOSPI bottomed in mid-June of 1998 and surged 30% over the next four weeks. The S&P rose 10% during the same period.

On July 17, the S&P hit an all-time high before falling 20% over the next three months as Russia plunged into crisis and Long Term Capital Management nearly collapsed. For the first month of this decline, the KOSPI tracked the S&P. From then until October 8, when the S&P bottomed, the KOSPI rose several percent while the S&P fell more than 10%.

Although the S&P's mid-1998 correction had its roots in emerging-markets turmoil and Korea was one of the largest emerging markets at the time, the KOSPI notably outperformed the S&P. That set the stage for it to rise nearly 250% from October 1998 through July 1999. The S&P rose 50% over the same period.

2003: The NASDAQ 100
The NASDAQ 100 and the S&P 500 both peaked in March 2000. The S&P made a double peak in August 2000, at which point the NASDAQ was 15% off its March high. From August until October 2002, the NASDAQ and the S&P both fell significantly, with the NASDAQ falling further and leading the way down.

The NASDAQ made its intraday bear-market low on October 8, 2002. The S&P's intraday low came two days later. The NASDAQ and S&P surged together over the following two weeks, but then their fortunes diverged. Over the next 4 1/2 months, the NASDAQ was flat while the S&P fell 10%. At first the NASDAQ made a series of higher lows while the S&P made a series of lower lows; then the NASDAQ fell modestly while the S&P fell more.

On March 11, 2003, the NASDAQ was flat compared to its month-ago price while the S&P had fallen several percent. March 11 was the start of a big upward move for both indices, and from then to the end of 2003, the S&P rose more than 35% and the NASDAQ rose more than 50%.