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KAEPPEL’S CORNER: The Best of Times and the Worst of Times
By Jay Kaeppel, Optionetics.com
4/4/2006 11:00 AM EST

http://optionetics.com/articles/article_full.asp?idNo=14583

I embarked on an interesting experiment a week ago. I went on vacation to Florida and for six full days I had no access to a computer. Pretty gutsy, huh? I refer to it as “beach therapy.” Sure, I woke up in a cold sweat a few times muttering something about “May Soybeans” one night and “Fidelity Select Energy” the next. But, surprisingly, all in all it went pretty well. Even more surprisingly, my portfolio wasn’t wiped out while I was away. And while I am sure that I missed an opportunity or two in the interim, I think it was worth it in the end. I'm back, I feel good and I’m tan to boot. Not bad for a week’s work. I consider this one of the benefits of relying primarily on a systematic approach to trading. While I’m away the systems that I have in place kind of take care of things for me.



Anyone who has read my work in the past knows that I am fond of the saying “There is always a bull market somewhere.” In fact, I like it so much that I wrote an article by that very title on 3/8/06 (see There’s Always a Bull Market Somewhere). Based on this theory I have done a lot of work with systems that involve trading industry groups and as a surrogate, sector funds. In the 3/8 article I detailed one of the simplest yet, interestingly, one of the most effective methods I’ve ever developed for investing “where the bull market is.” In a nutshell, I prefer to invest in the strongest funds in the hope that they will continue to outperform the market. Still, one question I often get is “does in ever make sense to invest in weak sector funds?” The hope is that by buying into a sector when it is “oversold,” you might be able to garner large profits in a short period of time when the sector rebounds. Does this make sense? More importantly, does it actually work? Let’s take a look.

THE BEST OF TIMES, THE WORST OF TIMES

In the past I written in several places about a strategy I developed that I call “The Best of Times, The Worst of Times” strategy (sounds pretty dramatic, eh?). The idea is to build of portfolio of top performing sector funds combined with several funds coming off of a period of under performance. In other words, instead of trying to decide whether one should be in the areas that are currently performing the best OR taking a shot at riding a rebound in oversold sectors, the idea is to do both concurrently. As you have undoubtedly deduced by now, there are two parts to this strategy. They are, ahem, “The Best of Times” and “The Worst of Times.” Let’s take a look at these two components separately.

THE BEST OF TIMES

“The Best of Times” portion of this strategy works exactly like the Pure Momentum System I detailed in the 3/8/06 article, with two important exceptions. First off, the Pure Momentum System ignores Fidelity Select Gold [FSAGX] completely. The Best of Times system will include FSAGX in the portfolio if it is one of the top ranked funds.

The other exception is that the Best of Times system is updated quarterly while the Pure Momentum System is updated at the end of every month. While updating once a month is not terribly onerous in my opinion, for some reason I have encountered many people who are reluctant to “trade too often” when it comes to Fidelity Select sector funds. This is typically due to the fact that Fidelity imposes a 0.75% fee for trades that are not held for at least 29 days. While this is almost never a factor when using Pure Momentum, there can at times be something said for giving things a little longer to play out rather than adjusting every month. With this in mind, “The Best of Times” strategy works as follows:

At the close of trading each quarter (March 31st, June 30th, September 30th, December 31st), identify the five Fidelity Select sector funds which have performed the best over the previous year (technically I look at 240 trading days).
Buy the top five funds and hold them until the end of the next quarter.
So, basically, there are four adjustment periods every year. Some quarters there is a lot of turnover in the portfolio, some quarters there are one or two changes, and occasionally there are no changes at all. That’s all there is to it.

THE WORST OF TIMES

I did a study awhile back which looked at buying the worst performing sector funds. For those of you who want to believe in the “buy ‘em when they’re down” approach, the news is not good. The results were dismal. The approach I looked at actually underperformed a buy-and-hold approach. And I hate the buy-and-hold approach. The problem as I see it is simply this. As I discussed a few weeks ago, changes to fundamentals for a given industry typically take a long time to play out, both on the upside and the downside. So, typically, rushing in to buy the “dog” industries while they are “still barking” is a bad idea. Still, nothing goes down forever (Okay, the horse buggy industry has yet to rebound). So when does it make sense to “buy ‘em when they’re down”? From my research the answer to that question is “after they’re not down anymore.”

So here is the theory. The fundamentals for Industry X deteriorate. Industry X embarks on a prolonged decline. That includes of course, the prices for the stocks in that industry. Eventually the fundamentals and the stock prices bottom out. Over a period of time, while market players wait to see if the fundamentals are in fact taking a turn for the better, the stocks in the industry, and the industry as a whole, start to form a base. This can go on indefinitely, but the research that I’ve done shows that a year is about right. Ultimately, after a prolonged decline and a year to base, the fundamentals improve and the industry group begins to advance. That’s the theory I worked with anyway. The next step was to develop a method to take advantage of this pattern. Here’s what I came up with:

At the end of each quarter, identify that sector funds that performed the worst over the two year period ending one year ago. In other words, on 3/31/06, we want to find the funds that performed the worst between March of 2003 and March of 2005. By so doing we have identified the sectors that have suffered the most – or as is the current case, were up the least - during that period. We have also given these sectors 12 months to bottom out and form a base. The hope is that they will soon emerge as good performers once again.
Buy the five worst performers from the period described above and hold them until the end of the next quarter.
THE RESULTS

The results for the two components of this approach, as well as the combined results, appear in Table 1.

Year
Best of Times Portfolio
Worst of Times Portfolio
Combined Portfolio

1993
+19.9%
+31.6%
+25.8%

1994
(-6.7%)
+12.0%
+2.7%

1995
+36.7%
+37.6%
+37.2%

1996
+18.9%
+20.0%
+19.4%

1997
+27.5%
+9.7%
+18.6%

1998
+14.5%
+11.5%
+13.0%

1999
+109.7%
+14.3%
+62.0%

2000
(-20.1%)
+38.8%
+9.3%

2001
(-1.3%)
+4.9%
+1.8%

2002
(-2.3%)
(-8.6%)
(-5.4%)

2003
+20.0%
+48.4%
+34.2%

2004
+18.6%
+6.7%
+12.6%

2005
+29.6%
+4.0%
+16.8%

2006* +7.2%*
+5.5%*
+6.4%*





Average +20.4%
+17.8%
+19.1%

Std. Dev.
31.3%
+16.6%
17.8%

Reward/Risk


0.651


1.072


1.073


Table 1 – Best of Times, Worst of Times Results
* - through 3/31/06

A few points of interest regarding the results in Table 1:

On an annualized basis, the Best of Times outperformed the Worst of Times by 2.6 percentage points per annum (+20.4% versus +17.8%).
On a year-by-year basis, the Worst of Times has actually outperformed the Best of Times 7 out of 13 calendar year. This argues well for the idea of using both systems in conjunction (i.e., it is essentially impossible to “predict” which system will perform the best in the quarter or year ahead).
The Worst of Times experiences only about 52% as much volatility as the Best of Times (an annual standard deviation of 16.6% versus 31.3% for the Best of Times).
The combined systems generated only 1.3% less return per year than the Best of Times alone, but did so with only about 56% as much volatility as the Best of Times alone (17.8% annual standard deviation for the combined portfolio versus 31.3% for the Best of Times alone).
The combined portfolio held up well during the 2000-2002 bear market, actually showing a small profit despite always being fully invested. The worst calendar year was 2002 with a manageable loss of –5.4%.
The current portfolios are as follows:



The Best of Times
Gold [FSAGX]
Brokerage [FSLBX]
Energy Services [FSESX]
Natural Resources [FNARX]
Energy [FSENX]

The Worst of Times
Pharmaceuticals [FPHAX]
Biotech [FBIOX]
Health Care [FSPHX]
Software [FSCSX]
Paper & Forest [FSPFX]

Chart 1 shows the top performer over the past 12 months, which is Select Gold [FSAGX]. Chart 2 shows the worst performer from the March 31st, 2003 through March 31st 2005 period, which is Select Pharmaceuticals [FPHAX]. It is interesting to note that although it was the worst performer for that period it actually showed a small profit. It just so happened that that gain was the smallest gain of any Fidelity Select sector fund during that period.


Chart 1 – Fidelity Select Gold [FSAGX]


Chart 2 – Fidelity Select Pharmaceuticals [FPHAX]

SUMMARY

One of the most useful things that any investor or trader can do is to realize that there is no “one best way” to approach the markets. Many system developers spend years attempting to develop that one great system that always makes money. And time goes by and their search continues. In many cases it is ultimately a combination of ideas that allows successful investors to achieve their maximum success. The Best of Times, the Worst of Times System is by no means flawless. Still the real point is that it illustrates just one way to combine two different objective and reasonable approaches into one method that has consistently beaten the market over the years and with reasonable volatility.

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Jay Kaeppel
Staff Writer and Trading Strategist
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