The loser’s index

Indexing top losers and winners could be an easy way to identify, capture performance and illustrate performance cyclicality.
The whole idea of performance is about benchmarking, good stock picking, losing less and of course making a profit. Behavioral Finance talks about a simple approach to performance, buying the losers and selling the winners.  It was during a conversation with an economist friend that we conjured up the idea of the loser’s index, an indexing technique combining the behavioral approach and time triads.
The behavioral approach is simple and powerful but does not spend much time explaining the time aspect. One could adopt a strategy of buying top annual losers and selling top winners or reduce the time horizon to quarterly and monthly duration? Buy the top month over month losers and selling the top month over month winners. Will it work?
As we have illustrated on prior occasions, performance cycles work at all time frames and behavioral approach of buying losers and selling winners endorses performance cyclicality. We wrote about numeric ranking based on performance cycles last week. This week we extend the idea of numeric ranking to generate trading or investing signals. If numeric ranking, performance cycles, time triads are connected then buying losers and selling winners is a quantified exercise, which can be repeated on any time frame.
The idea is to rank top performers and underperformers on a certain time frame. If the idea of performance cyclicality works, then any top performer could be an opportunity to sell and not buy. On the other hand if you have a well diversified portfolio entering a top underperformer could not only be a good stock pick but also reduce the relative risk of the overall portfolio in case of a meltdown. Performance cycles offer a natural hedge and reduce portfolio risk. The investor is just unloading the best performers and loading on worst underperformers. When market turns down, the performers may be less affected compared to the top most of the 30 blue chip stock. Even the top of the market sectors may not find it easy to sustain its number 1 spot. Like they say, “being number 1 is easy, but remaining number 1 is a rare feat”. Stock markets cycles are more pronounced so a top ranked performer should be sold rather than bought, as what an investor needs is also relative performance not just a blue chip to take home.
We took the top 10 sector indices viz. CNXIT (TECH), BSEBANK, BSE OIL, BSE METALS, BSEHC (Health Care), BSECG (Capital Goods), BSECD (Consumer Durables), BSEFMCG (FMCG), BSE500, BSESC (Small Cap) and ranked their performance against SENSEX. For the study monthly performances were measured.
We got the following backtested signals. CNXIT was the worst performer in Jan 2009 for the month over month compared to Nifty among all the 10 sector indices under study. The monthly worst performer turned up 227% since Jan 09. April 08, BSEOIL was the best performer among the group. The sector Index dropped 46% in 8 months. Starting Mar 08, BSEMETALS (barring Apr 08) was the month over month best performer till Jun 2008. The cycle turned against the leader as it fell 73% from July till Dec 08. BSEHC was a top performer for July and Aug 08. Prices fell 36% from Aug 08 till Feb 09. Though such uncanny accuracy should leave the idea of performance cyclicality clearer, these signals can be considered as guidelines not rules.
Where are we now? BSEBANK was the top performer month over month across sectors. Whether this is an unloading time or loading time on banking stocks becomes a fundamental question, cycles suggest unload, reduce or short based on an investor’s risk profile. Another sector that ranked top last month was BSESC (Small Cap). An emerging market fund manager asked me about the relentless rise in small cap stocks. The top performance in small cap only suggests that performance has outpaced the sector and time should do some catch up now. This may be a tough question for bulls to digest as they are now in charge. But a seasoned bull understands performance and time cycles better. He also knows that when we start asking if “Nifty will ever crack?” The turn is near.
Secular trends don’t happen just because of one sector but owing to confluence of upsides. If Technology and Banking is in a one way performance of multiple months, it’s time for the sectors to underperform. Even if markets don’t move down, the tech and banking holdings should not deliver relative alpha from here. We consider this a low risk entry point for shorts on banking and tech. If future shorts look difficult, Options on SBI, NSEBANK and INFOSYS for DEC seem a conservative bet.

About the loser’s index? Instead of looking at top performers look at top losers, numerically rank them and buy and hold till they travel up the performance hierarchy. This is a statistical exercise and like everything else is connected with time, another name for the time index.