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.
