Are Leaders or Laggards Better Long-Term Bet?

Every day, many highly paid people on Wall Street try to predict where the stock market will be in two hours, a week, a month, six months.

It can all make for entertaining reading for the average investor. But is it relevant?

Not if your stock holdings are primarily long-term investments. “Long-term” means different things to different people, of course, but if you can say that you’re investing for at least five years from now (i.e., you won’t need the money before then), you’re a long-term investor.

Your goal, then, should be to maximize stock returns over that extended period, within the limits of your tolerance for risk and short-term volatility.

If you want to earn the highest possible returns between now and mid-2004 (five years hence), which stock market sectors should you be in today, and which should you avoid?

Without help from the Psychic Friends Network or someone else with a purported line to sources in the hereafter, many investors attempting to identify the next market leaders (and laggards) will end up basing their decisions on recent history. If a stock sector has been hot lately, then it might very well stay hot, people often assume.

And if a sector has been cold, it might very well remain cold.

This is essentially “momentum” investing--following the herd rather than going against it. Yet despite the often negative connotations of momentum investing (“It’s for sheep!” critics cry) it can be a quite profitable strategy.

Why? For the simple reason that once a trend is in place--any kind of trend, not just an investment trend--it can stay in place for a very long time.

(For a fascinating perspective on this issue of the duration of things, pick up the current [July 12] issue of the New Yorker magazine and read the profile of astrophysicist J. Richard Gott.)

Let’s go back exactly five years, to mid-1994, and assume that you wanted to position your portfolio for maximum returns by mid-1999.

You couldn’t know for sure what would happen to the U.S. economy in the ensuing five years. Almost certainly you wouldn’t have foreseen the Asian economic crisis--or the spectacular rise of the Internet, then in its infancy.

But looking back on the prior five years, from mid-1989 to mid-1994, you would have known this much:

* Financial-services stock mutual funds were the top-performing fund sector in that period, soaring 124.2%, on average, as shares of banks, brokerages and insurance companies rocketed in the early 1990s as interest rates declined.

The financial funds’ gain was double the 61.8% gain of the average general U.S. stock fund, according to fund tracker Lipper Inc.

* The second- and third-best-performing fund sectors were health care, up 114.5% (despite the plunge in drug stocks in 1992-93), and technology, up 104.2%.

* Among general diversified stock funds, the biggest gainers were funds that focused on stocks of mid-sized firms, up 81.8% on average. That gain was well above the 58% rise in the typical big-stock (growth and income) fund in the period and the 73.7% average gain for small-stock funds.

* Among foreign-stock funds, the big winners were Pacific-region funds, with a five-year average gain of 75.4%. They trounced the typical European-region fund, which gained just 39.7%.

What about the now-revered Standard & Poor’s 500 index funds, which simply replicate the performance of that blue-chip index? Their five-year average gain was 58.8% as of mid-1994--hardly something to brag about and well below the average returns of funds focused on smaller stocks.

So if you had built a five-year portfolio in mid-1994 based on the previous five years, how well would you have been rewarded?

Surprisingly well indeed. As the accompanying chart shows, the three best-performing U.S. stock fund sectors of the 1989-94 period--financial services, health care and technology--were again among the leaders in the five years ended June 30. Tech was by far the star, up 316.6%, on average.

Meanwhile, funds that target mid-sized stocks, up 149.3% on average over the last five years, were again a better choice than small-stock funds (up 118.3%).

But betting on the 1989-94 leaders alone, and ignoring the laggards, would have cost you money on two counts.

First, you would have avoided S&P; 500 index funds, which went on to become the second-best-performing fund category in 1994-99, after tech.

Far worse, you would have bet on Asia and ignored Europe. The average Pacific-region fund has lost 8% over the last five years (even including this year’s sharp rebound) while European-region funds have gained 112.5%.

Still, an assumption in 1994 that other laggards of 1989-94 would stay that way was the right bet in the case of Japan funds, gold funds and natural resources funds. They were ice-cold then and remained so for much of 1994-99.

What about the next five years? Do you stick with the leaders of the last five years--or buy the laggards?

Certainly, the biggest difference between now and 1994 is that stock valuations are so much higher, especially for favored groups such as tech, health care and blue chips. That means the risk in owning those hot sectors also is higher.

But if you’re truly investing for 2004 or beyond, giving up now on tech seems silly. Will the world want less technology five years hence? You can argue the same for health care and for financial services. Long-term, these are still great growth industries.

As for bargain hunters, making a modest bet on Asia for the next five years (or emerging markets generally) seems like a move with decent reward potential versus the risk. Many Wall Streeters say the same about U.S. small stocks, although history suggests that if the choice is small stocks or mid-sized stocks, the latter still have a better risk-to-potential-reward trade-off.

What about S&P; 500 index funds? This may be the most telling statistic: Those funds still hold less than 10% of total U.S. stock fund assets. That means there are many investors who haven’t yet bought into the indexing idea--but who probably will.

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.

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Buy the Leaders--or the Laggards?

If you were building a portfolio today based on the stock leaders of the last five years, you would load up on technology, financial-services stocks and big-name blue chips. A bargain hunter, on the other hand, might be buying Asian funds, gold funds and real-estate-oriented funds. Stock mutual fund sector average performance for three periods:

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Total return Total return Total return Stock fund sector 1994-99 1989-94 year to date Technology +316.6% +104.2% +38.9% S&P; 500 index +234.4 +58.8 +13.8 Growth +182.6 +60.9 +13.6 Financial services +181.9 +124.2 +7.7 Growth and income +169.5 +58.0 +12.2 Health care +163.9 +114.5 +0.1 Avg. general U.S. fund +161.2 +61.8 +12.5 Mid-cap +149.3 +81.8 +13.3 Small-cap +118.3 +73.7 +9.5 Europe region +112.5 +39.7 +0.9 Micro-cap +103.0 NA +22.6 Real estate +63.9 +44.1 +4.8 Natural resources +52.3 +36.2 +29.6 Emerging markets --5.9 +72.8 +38.4 Pacific region --8.1 +75.4 +37.7 Japan --12.1 +22.4 +42.2 Gold --45.9 +25.1 --7.5

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NA = Not available (sector wasn’t tracked in the period)

Source: Lipper Inc.