I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

Now, as a bonus to Aleph Blog readers, I’ll share with you my second industry rotation model, which I put out weekly to clients.? This model looks at the S&P 1500 Supercomposite, and using price momentum, among other factors, encourages the purchase of equities that have done well over the past? year.? Comparing it to the first model, this report always works in the red zone, because price momentum tends to persist in the short run.? This is a short term model.

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I’m not saying to change if things are working well.? I’m saying don’t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

Anyway, consider this, and if you have more good ideas on industries, share them with the group.? I can always learn more.

I didn’t talk much about it at the time, but I had a hard drive crash around February 1st of this year, and it wiped out my main industry rotation model, and many other things as well. My last backup of the model was eight months earlier — I resolved to become better at backing up my data.

To do that, I back up my main files using a free service from Microsoft, mesh.com, in a way they didn’t intend.? Mesh is a way of synchronizing files across computers painlessly.? Well, almost painlessly; it is a bit of a bandwidth hog.? I turn it on for fifteen minutes each day, and updated and new files are replicated in cyberspace.? If I accidentally destroy a file, I can restore it.

Back to my dilemma in February — if I didn’t have my main model, at least I had my secondary model.? The secondary model was derived from a set of pieces written here (one, two), about four months ago, about the time that the momentum anomaly began to become overused (and right prior to the hard drive crash — I need to rebuild that model as well — I know its main result, but my proof is gone).

Fortunately, the two models give fairly similar results, although the secondary model predicts monthly performance, and my main model, annual performance.? The choice becomes what mode to use the model in — value/mean-reversion mode (cool-green), or momentum mode (red-hot).? Typically, I work in value mode, but recently I have been taking ideas from both the red and green zones.

There are two ways to do industry rotation.? In the green zone, the question is “Where has hope been abandoned?”? Buy the financially strongest companies there, and when the cycle turns (it always does, except for buggy whip industries like newspapers), you will do well.? In the red zone, the question to ask is, where have trends been underdiscounted?? In that case, buy companies of reasonable strength that will benefit from the persistence of the trend.

I have highlighted a few areas that I would consider at the top of the graphic, where it reads “dig through.”? You may see other opportunities that I don’t.? Either way, be careful as you select industries to invest in.? Careful selection pays off.

There have been a lot of posts on the power of the momentum anomaly lately.? To mention two, there was my post, A Different Look at Industry Momentum, and a post by Mebane Faber at his excellent blog World Beta, Quantitative Strategies for Achieving Alpha.? I know there have been more recently, but somehow I did not bookmark them.

Tonight’s note considers whether the strength of the momentum effect might not be waning.? Consider this:

This graph shows the excess returns of my industry momentum model over the past twelve years.? Momentum has worked over that time period, but deceasingly so, with a few wipeouts along the way.? Many will remember the worst of them in August 2007, when quantitative investing was decidedly crowded.

Remember, I view investment strategies using an ecological framework.? There are many strategies that work on average, but often many of them are overpursued, and the excess returns have been competed away.? Or, a strategy has been forgotten, relatively speaking, and now it might have some punch.

I am guessing that momentum as a factor is overplayed at present, and it might be wise to leave it to the side until the next wipeout.? If that were to apply in the present market, it would mean the failure of the more stable parts of the market to retain value: consumer staples, utilities, health care, other cash flow spinning industries.

There are two ways that could happen: 1) a resurgence of the cyclicals, and 2) market collapse, where investors give up on all stocks, even stable ones.? I’m not going to bet on either of those, but either is possible in this environment.? If demand begins to rise in the world due to falling commodity prices, #1 is possible, and #2 would come from a continuing collapse in consumer demand.

Food for thought in this ugly environment. Invest carefully, the need for a margin of safety is more critical than ever.

I’m gearing up for the next change in my portfolio, but unlike prior reshapings, I am putting out my industry ranks first.? As I have mentioned before, the rankings can be used in value mode (green) or momentum mode (red).? That reflects two different philosophies on investment turnover and time horizons.

I am still negative on the banks, and think the present relative strength will reverse.? The same for housing-related industries… there is more weakness to come.

For those playing momentum, with a few exceptions, the industries in the red zone are industries with stable cash flows.? That is another sign of risk aversion in the present environment.

I will be putting out my replacement candidates later this week; at present, I’m not sure what way my portfolio will move.? These are unusual times, and I am focused on survivability, and after that, cheapness.? Safe and cheap, with the accent on safe.