Reversion to the mean – the tendency of winning sectors to become losers – is one of the most profitable investment themes to follow, no matter what the market. The time frame over which this happens varies – five-year time periods work well in the analysis below – but the larger problem is that very few investors, including myself, have the discipline to follow what the numbers tell us.
The first chart shows TSX sector performance from 1995 to 2005, broken into five-year periods. The return numbers are ranked left to right by top-performing sectors from 1995 to 2000. On the far left, for example, information technology generated the biggest profits from 1995 to 2000 and telecom stocks were second-best.
The pattern doesn't work perfectly, but there was a clear trend that the top-performing groups of stocks in the 1995 to 2000 period became the worst performers in the next five years. The opposite case was also consistent – the worst performers became the best. The most obvious examples were technology stocks, which went from No. 1 to dead last in terms of returns, and energy stocks, which moved from the eighth-best performer in the five years ended in May of 2000 to the best-performing sector from 2000 to 2005.
The same market tendencies are apparent in the most recent decade, as this next chart illustrates. Materials stocks, like technology in the previous 10 years, went from the top-performing group between 2005 and 2010, to the worst sector for 2010 to 2015. Health care made the opposite trip, moving from worst to first.
We are dealing with longer-term time frames here so investors should avoid interpreting the results as short term, tactical trading advice. Nonetheless, market history strongly suggests that health care, consumer staples and consumer durables stocks are the ones to avoid in the coming years. Perhaps surprising, the analysis suggests that materials and energy stocks are more likely to be top performers from now until 2020.
Following the advice inherent in these charts is extraordinarily difficult in a psychological sense because it involves selling the most successful stocks in the market in order to buy the weakest performers. Peter Lynch, the former Fidelity portfolio manager, once disparagingly called this process "watering your weeds and pruning your flowers."
Reversion to the mean should, by no means, be the sole guide to portfolio-sector allocation. It does, however, provide an effective rule of thumb that has worked over time. Investors with heavy portfolio allocations to the top-performing sector of the past five years should probably take at least some of their profits, and look for new opportunities in the biggest-losing sectors of the past five-year period.
Follow Scott Barlow on Twitter @SBarlow_ROB.