Time to Go to the Bull Pen?

Story Highlights:

• Sector weightings are one of the key drivers of portfolio performance.
• Distinguishing short-term counter-trends from true inflection points is one of the keys to outperformance over time.
• For some time, Materials and Energy stocks were leaders and Financials stocks laggards. In the last week, the roles reversed. Is this a new trend, or just a short-term counter-trend?

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Just like a starting pitcher in the late innings, the winners in your portfolio won't tell you when they're getting tired. But knowing when to send them to the showers is one of the critical pieces of a successful season in the markets.

"Well, there's runners on first and third, two out, Bulls up 4 to 1 in the 7th and Grizzly on deck."

"To the belt, aaaand the pitch…….ball 4! He's loaded ‘em up for the Bears' slugger, Jim."

"He's getting tired, Bob."

If you're a long-suffering sports fan, you've no doubt weighed in on whether your pitcher / quarterback / pugilist has had enough. (Yes, we're talking to you Brett Favre.) And if you're being honest, you can remember more than a few times when you've been proven wrong. Hey, if it were that easy you'd be in a dugout somewhere calling all the shots and making millions too.

It can be just as tough being the manager of your investment portfolio. There will be days when the market might be headed up, but your portfolio just sits there. Is it getting tired? Time to make a change?

Let's look at the stats. Repeated studies have shown that over time, aside from being in the stock market in the first place, most investment return is derived from the category of stocks in a portfolio—e.g., Technology vs. Industrials, US vs. Foreign etc. (Surprising to many, these weightings have a much greater impact than individual stock selection—e.g., GM vs. Ford.)

But knowing which kind of stocks will outperform is tougher than just jumping on a Yankees bandwagon: Markets are efficient and dynasties hard to come by. In other words, markets are also cyclical—different areas of the market take turns leading the way. This is because as a given area takes off, more shares are brought to market (through IPOs and other issuance) to keep up with demand which—all else being equal—ultimately brings down share prices. An extreme example of this was Technology back in the late 1990s. Demand from those who viewed Technology as a permanently outperforming area led to a glut of new share issuance, eventually helping to form the Tech bubble.

So the trick is to own outperforming areas while they're hot. In order to do this, you'll need to distinguish longer-term trends from short-term market gyrations. Energy and Materials, for example, have been bright spots in a tough year so far, vastly outperforming areas like Financials. But recently, oil prices suffered the second largest one-day decline in history, bringing Energy stocks down with them. And at nearly the same time, Financials (which have taken a drubbing for most of the year) rallied sharply. Are the trends reversing? Or are Financials getting the proverbial "dead cat bounce" while Energy takes a breather? This is one of the more important issues facing investors at the moment, yet you don't hear much about it in the media. Go figure.

Regardless, the question is whether a change is warranted. To answer it you'll need to decipher whether underlying fundamentals are pointing to a true inflection point or a just a short-term countertrend. If you believe global demand growth will continue to outstrip new supply for energy, you might want to own Energy despite its recent volatility. If you think the global economy is grinding to a halt, you might be on the other side of that trade.

So go out to the mound and have a few words with your starter. He won't come right out and tell you what to do, but most of the time he won't have to.