As investors look ahead to 2013, there's much speculation about which asset classes and sectors of the stock market are likely to perform best. To zero in on some of the likely candidates you may want to begin with a list of the recent worst performers.
You see financial markets tend to be mean-reverting over time, which means the last shall be first and the first shall be last. This is the first rule of contrarian investing.
For example, can you remember one of the best performing major asset class of 2011? How about U.S. Treasury bonds?
After the U.S. lost its AAA credit rating … and during multiple flare-ups of the euro-zone debt crisis, 10-year Treasury notes benefited from a flight-to-safety trade, driving government bond prices higher and interest rates lower.
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In spite of a paltry yield, the 10-year Treasury offered investors a total return of 8.87 percent in 2011. Those gains far outpaced U.S. stocks, which were essentially flat in 2011. But fast forward to 2012 and see a reversal of fortune between these asset classes.
U.S. Treasuries are up just 0.92 percent this year while the S&P 500 Index is on pace for a total return of 16.01 percent.
The same first-to-worst dynamic also plays out among individual sectors within the stock market. Case in point: Utility stocks were the best performing among the ten S&P 500 sectors in 2011 with gains of 19.96 percent. But in 2012 utility shares are falling behind, up 1.93 percent year to date.
Meanwhile, financials were the second-worst performing sector a year ago posting losses of 17.02 percent. But in 2012, financials are leading the pack up 28.78 percent. I have seen this same first-to-worst (and vice versa) dynamic at work in commodity markets and even among countries. The best performers one year have a habit of being humbled, while the worst performers rise again.
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Human Nature at Work …
The reason for this dynamic is partly due to the cyclical nature of financial markets and economies. But there's also a healthy dose of investor psychology at work too.
It's human nature to be attracted to what works and avoid what doesn't. Asset classes and sectors that perform best attract more money from trend-following investors expecting the outperformance to continue. Meanwhile, investors tend to yank money out of poor performing assets and stocks for fear of further loss.
But at times, this fear-driven selling can reach such an extreme that contrarian investors should consider stepping in to buy what others are selling.
When an asset class or sector gets so out of favor with investors that it's given up for dead … and no one on CNBC talks about it anymore (or if they do it's in a bad way) … that's the time to do your homework to see if you might have a worst-to-first candidate on your hands.
Most markets and asset classes worldwide rose in 2012 and there were few outright losers. Commodities were the exception. The Thomson Reuters CRB Commodity Index is down 4.01 percent year-to-date and many individual commodities have performed far worse. While gold and silver are still hanging on to modest gains for the year, crude oil has tumbled 10.34 percent year-to-date.
Energy stocks are likewise the second-worst performing sector (after utilities) of the S&P 500 Index in 2012, up just 4.85 percent while the overall index has performed three-times better.
Energy Could Be Set for a
Gigantic Turnaround in 2013!
Domestic oil production has been increasing at such a fast pace, thanks to new technology, that the U.S. is set to become the world's largest producer before this decade is out. Booming U.S. oil and gas production may keep those commodity prices volatile in the year ahead, but many domestic producers included in the S&P Energy Sector should benefit. That's why energy stocks look like a good bet to move from worst-to-first in 2013.
I'm focusing on ETFs and selected stocks that are best positioned to capitalize on the great American energy boom. This includes oil and gas equipment, and service stocks. Essentially, they are supplying the "picks and shovels" that makes the domestic energy boom a reality. Also, master limited partnerships (MLPs) are poised to benefit in a big way, as these companies get paid to transport and store the increased production of oil and gas.
Energy shares have indeed been laggards in 2012. But I'm expecting a reversal of fortune in the year ahead that could catapult this sector back into a leadership position.
Good investing and Happy New Year,
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