Blog - Investing Notes

June 7, 2006 - Update: Market-Leading Industries

A reader who is a strategist at a European equity hedge fund, alerted us to an (off-SSRN) update of a previously summarized paper. We update that summary here. More from the reader below...

Do certain industries tend to lead or lag stock market cycles? In the November 2004 update of their paper entitled "Do Industries Lead the Stock Market?", Harrison Hong, Walter Torous and Rossen Valkanov investigate whether returns from some industries predict future returns for the overall stock market. The authors hypothesize that the overall market only gradually recognizes valuable information contained in the returns of specific industries. Using U.S. data for 1946-2002 and international data for 1973-2002, they conclude that:

• Commercial real estate, agriculture, nonmetallic minerals, apparel, furniture, print, petroleum, leather, metals, transportation, utilities, retail and financial lead the market by up to two months. Financial, retail, print and commercial real estate are the strongest predictors. While most of these industries lead the market by one month, petroleum and metals can forecast the market (contrarily) two months out.
• The ability of an industry to predict the market correlates strongly with its ability to forecast indicators of economic activity such as industrial production.
• Potential stock market timing strategies based on industry signals produces lower mean returns, but slightly higher Sharpe ratios, than a simple buy-and-hold approach (excluding transaction costs). However, these strategies require frequent trading, and transaction costs would therefore be significant.
• The overall market, because it is widely followed, leads a only handful of industries.

In summary, some industries (such as financial and retail positively, and petroleum and metals negatively) lead the overall stock market. However, the indications are not economically significant for traders.

Our contributing reader notes:

The 2004 update of this paper added a very valuable analysis (on pages 18 and 41): the performance review of a trading strategy based on the signals of "predictive industries." The results show little or no outperformance for this strategy (Sharpe ratio 0.49-0.52) compared to simple "buy-and-hold" (Sharpe ratio 0.46). This result is very surprising (and disappointing), given the very strong evidence presented in the paper, but out-of-sample market performance is the ultimate test for investors/traders. We performed a similar analysis (before the update of the paper), and found no compelling results for any trading strategies.

The authors' conclusion that there are "leading industries" is either a statistical fluke, or it is true but not significant enough to compensate for the risk. It is also surprising that the authors view the trading strategy results as supportive of their thesis (even while they exclude trading costs)!

For related research, see our Blog Synthesis: The Economy and the Stock Market.