Will The Market’s 2013 Winners Also Be Winners in 2014?

As the headlines proclaim, the stock market produced unusual gains in 2013.

Be careful how you react.

It’s common knowledge and well documented that one of the most costly mistakes investors make is to chase performance.

The long-term investor pattern is one of not buying into bull markets until very late in their uptrend, after they have already made great gains, and then buying enthusiastically. The similar shorter-term pattern is at the end of each year to review ‘Top 25 Mutual Funds’ lists, ‘Best Stocks of the Last 12 Months’, “Best Strategy of the Year”, and jump out of under-performing holdings and strategies into the stocks and strategies that were the top performers the previous year, or for the previous three years.

How great an approach is it even on its surface, to bail out of a mutual fund or a strategy after it disappoints and may be at a low, and buy into one that was up significantly the previous year, considering that the most obvious rule for successful investing is to buy low and sell high?

Yet as David Dreman, CEO of Dreman Value Management says, “How quickly investors flock to better-performing mutual funds, even though financial researchers have shown that the "hot" funds in one time period very often turn out to be the poorest performers in the next period.”  

Indeed, many studies have shown that a list of the previous year’s losers is more likely to be fertile ground for finding the following year’s winners, as they are more likely to be oversold and due for a reversal to the upside.

John Rekenthaler, vice-president of research at fund-ranking service Morningstar Inc., says that almost always “Investors piling into the hottest funds of the previous period will be sorry, since the lower ranked funds tend to be the winners over the next three-year period”.

The same pattern holds true for investment strategies.

Every successful strategy runs into periods when it works exceptionally well, and periods when it underperforms. Abandoning a proven strategy after a period of underperformance to jump into one that just enjoyed an unusually positive period is usually a mistake.

Consider famous long-time successful investors and managers, and the list is long, the likes of Warren Buffett, George Soros, Bill Gross, Peter Lynch, John Paulson, et al.

All have significantly different investment strategies.

When one of them has an underperforming year, or two or three in a row, as they all periodically do, do they scrap their own long-time strategy and switch to that of one of their rivals who had an outstanding year? Of course not. Yet Buffett for example, has had several one to three-year periods when he was down as much as 45%. But they are disciplined, experienced, understand markets, stick with their strategy, recover and soon climb back to the top again.

Yet abandoning a strategy after even minor underperformance to jump into last year’s winners is almost the norm among public investors.

There is no shortage of lists of last year’s winners from which to choose.

However, if it is advisable for investors to choose instead from the previous year’s losers, let’s look at last year’s losers and consider whether they could be winners in 2014.

Among mutual funds and ETF’s anything related to gold was a big loser. Gold bullion plunged 28% in 2013 (and 37% since 2011). The gold mining stocks fared even worse. The XAU Index of Mining Stocks plummeted 49% in 2013 (and 63% since its peak in 2011).

As 2014 begins, I am watching them closely as they attempt to rally off their recent lows. We would need them to break through the overhead resistance that halted their previous rallies before our indicators could produce a buy signal.

However, if choosing from a list of previous losers is the way to go, gold and the mining stocks would surely qualify on that score.

Regarding strategies that disappointed in 2013, those based on the market’s annual ‘Sell in May and Go Away’ seasonality, would have to be on the list.

Over the long term they have significantly out-performed the market by avoiding market declines that most often take place in the unfavorable summer months.

In 2013 the market stumbled a few times in its unfavorable season when the Fed hinted it might begin to taper back its stimulus efforts. However, the market quickly recovered each time, and overall made further gains in the unfavorable season, and so seasonal strategies underperformed the market.

My similar Seasonal Timing Strategy, which employs the MACD technical indicator as well as the calendar, was up only 18.7% for the year, compared to the super 28% gain of the Dow. It also underperformed in 2012, gaining only 7.7% to the Dow’s 9.0%. That was two straight years of underperformance after significantly out-performing in 2011, with a gain of 15.8% to the Dow’s gain of 8.1%, and the S&P 500’s gain of only 2.1%.

So, will gold again be on the loser’s list in 2014, and stocks on the big winner’s list? Will Sell In May type seasonality return to its long-term pattern in 2014, or will choosing last year’s big winner ‘buy and hold’ work out again?

We might get some clues from the fact that next year is the second year of the Four-Year Presidential Cycle, and since 1934, the average decline within the second year was 21%, with declines tending to be worse when there was no correction in the first year of the cycle.

Or that, unlike a year ago, stock valuations based on Price to Book Value ratios and the like have reached high levels usually seen as significant market tops approach.

Or that, in the background, the Federal Reserve, which has provided the main support for the bull market with five years of continuous increases in its QE stimulus programs, will begin decreasing that stimulus this month with the goal of having it down to zero by next summer.

There will again be winners and losers in 2014. But will they be the same as those of 2013?

It definitely is something to think about when preparing for 2014.

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Sy is president of StreetSmartReport.com and editor of the free market blog Street Smart Post. Follow him on twitter @streetsmartpost. He was the Timer Digest #1 Gold Timer for 2012 (Gold Timer of the Year), as well as the #2 Long-Term Stock Market Timer.