Following the Early Birds in Stock Market Sector Reversals

Spotting trends early can reap returns for observant investors.

— -- Too many investors are focused on what may happen down the road instead of what is happening. Sure, the stock market is all about the future, but the future is now – what’s just starting to happen.

Some of the greatest investors in history have embraced the concept of value investing — buying depressed stock in industries that appear to be going nowhere and then reaping profits when they rise. These investors are called contrarians because they hold views contrary to those of the market.

Some economists say value investing can’t work because, in what they call an efficient market, all known information is already priced into stocks. Others believe that value investing can work because the time it takes for information to become known creates windows of inefficiency that investors may exploit to reap profits.

The key is to making it work is to be on the cusp, not late for the party. If you invest in a stock that you hear about from a friend or through the grapevine, you’re probably too late to get in on substantial gains because it’s already priced up. Instead, follow the money — the smart, early money that’s beginning to flow into stocks or sectors that much of the market still shuns. You can’t invest this way based on the headlines because not only are the headlines behind, but they also reflect what everyone knows or thinks they know.

Another current example is media stocks. In mid-October, 22 to 26 percent of stocks in this sector were experiencing an uptrend. By mid-November, this range had risen to 34 to 36 percent. This rise is hardly gangbusters, but it’s significant in a sector that many are down on, in part because of the financial struggles of the print media industry.

Though potentially significant to the careful observer, the increases in investment in these sectors aren’t pronounced enough to trigger widespread attention. The key is to find them before they become obvious and boost values to a high plateau, with no room for gains.

This hunt for money inflows, while business as usual for many professional investors who subscribe to expensive data services, is much tougher for individual investors. But perceiving nascent upswings isn’t beyond the capability of the resourceful.

The key is to use the information that is all around you and finding new, accessible sources. Investors’ Business Daily offers insights into sector money inflows. And while specialty data providers like Dorsey Wright may charge subscription fees, many offer free trials that you can get good mileage from. This data can also be obtained from various commonly known financial websites by drilling down behind the headlines about large shifts that are pointless to follow because the underlying stocks are already priced up.

To be a successful value investor, you need to develop something of a curmudgeonly contrarian mentality: You’re not concerned why a sector is starting to come up, only that it is. Often, successful value investors don’t learn the reasons for sector upswings until after they’ve picked up considerable steam. Yet, to some extent, it’s helpful for investors to have even a limited view into this causation for two reasons: 1) It gives them the comfort of conviction, helping them sleep better at night, and 2) depending on the solidity of their analyses, it might yield clues to the sustainability of a given upswing.

Understanding the reasons for initial turnarounds in money flows usually involves a basic grasp of the dynamics of the sector involved. This way, you can get a handle on the factors that much of the market may be ignoring.

Let’s look at some of the factors involved in the ascent of our three example sectors:

  • Oil. A key indicator of value in this industry is what oil companies are doing with each other. Halliburton, the massive oil-field services company, recently announced that it will purchase competitor Baker Hughes. Halliburton knows the oil business inside out, and its perception of near-term value by buying Baker Hughes reflects the principle that it can build its business cheaper through acquiring a competitor than it could through expansion. Oil magnate J. Paul Getty said that the cheapest place to buy oil was on the stock market – meaning, buying other companies at the right time.
  • For one thing, relatively new laws concerning contributions and disclosure of donors are certain to fatten campaign coffers, and thus the bottom lines of the media companies that will be selling abundant ad space and air time to campaigns for local, statewide and national office in a presidential election year — always a good cycle for the sector. For another, there’s some recent evidence that rumors of newspapers’ demise may, as Mark Twain famously said, be greatly exaggerated. Warren Buffett recently bought a gaggle of small newspaper companies, and some larger companies in the sector, such as Gannett, have been reporting some good numbers.

    As a reaction to the free-lending days of the real estate bubble and because of new regulations, mortgage lenders have been extremely tight-fisted in recent years. But as the economy improves and demand for mortgage loans grows, this can’t last; capitalism abhors missed opportunities.

    By no means will construction activity in the near-term be as brisk as it was during the peak in 2007, but it will likely be brisk again in the long-term. The pendulum will probably swing back, simply because the “echo boomers” need roofs over their head, too. And there are 10 million more of them than there are baby boomers.

    Therein lies a principle that applies to all sector shifts: To make money, you don’t need the pendulum to swing all the way back to where it was at a peak; you just need progress in a positive direction. Business in the sector doesn’t have to be booming; it just has to be improving.

    Any opinions expressed are solely those of the author and not of ABC News.

    Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.