There is a shortcut to identifying stocks that will become “buys” — and those that you may consider selling soon. How? Monitor the long-term performance of stock groups.

This analysis forces investors to listen to what the market is saying. Then, once investors get the message, they can apply fundamental analysis to what they find.

This way to screen the market for change starts by paying attention to the most depressed industry group on the Canadian market. At present, it is pharmaceuticals/biotechs. The next two worst-performing industries are capital goods and autos/auto components. These industries have the worst three-year performance — and are most likely to become significant buys in the year or two ahead.

In the other direction, long-term price changes say energy, diversified financials, and technology hardware and equipment can do no better, and are likely to underperform the market within the next three years.

The method works this way:

> Rank industry groups in the S&P/TSX composite index by their three-year price change.

> The three or four industry groups that have gained the most tend to underperform in the succeeding three years.

> The three or four that have the worst three-year performance are likely to outperform the market over the following three years.

> The time to re-examine an industry is when it drops out of the top ranks, or moves up from the bottom ranks. The fundamentals at that point may indicate buying or selling action.

Because an individual stock’s performance has a strong correlation to its industry group, watching the industries change from strength to weakness, and vice versa — which goes by the name “sector rotation” — then using fundamental analysis leads to decisions on individual stocks. The players in the market are always gradually shifting ground, but the experience of the past 25 years has desensitized many investors to this fact.

Energy has been a top-ranked industry since 2002. In that year, technology hardware stocks were the lowest-ranked. The technology stocks remained in the bottom ranks until April this year, then quickly reached the top ranks. That subindex gained 12% from April’s close to its high at August’s close.

Such volatility is unusual, but technology is a nervous industry. Energy’s long reign in the top-performance ranks shows how an industry can remain a leader when the market is trending strongly upward.

This is how the other three lowest-ranked industries in January 2002 have performed:

> Software/services remained among the bottom ranks into 2004. From its January 2003 price level, the industry group has climbed 28% in almost three years.

> The insurance index gained 31% in the three years following January 2002, and 44% to date.

> Retailing gained 50% in the following three years, and is now up 74% from its January 2002 level.

Consumer industries dominated the top-performing ranks in January 2002 and again in January 2003, with one industry group repeating in 2004. This is how 2002’s top performers have fared:

> Food/staples retailing has gained 39% since January 2003, but this was a below-average performance vs the S&P/TSX composite index’s 58% gain in the same period.

> Food/beverages/tobacco remained a top-ranked group through 2003. Since January 2004, the index has dropped 7%.

> Consumer durables/apparel has gained 10% since January 2003, when it was last among the top-ranked industries. This was also a below-average performance.

So, sector rotation is not a method of timing the markets; it is a way to alert an investor to potential changes in his or her portfolio. It does not replace fundamental analysis but helps the investor focus on the areas in which significant change may occur. It points to industries in which an investor is most likely to find bargains.

Nor is this infallible — no investment method is. Still, market leaders eventually fade and market laggards eventually revive, so their performance should be measured and compared. When an industry no longer ranks among the top three or four three-year gainers, it is time to have a serious new look at its prospects.

In bear markets, a previously low-ranked industry may be a superior performer simply by dropping less than the former leaders.

This approach to identifying areas in which change may be imminent applies to industry group divisions in the S&P/TSX composite index. There are 10 industry sectors in the index, and six are subdivided into industry groups. The total comes to 23, with the four undivided sectors (energy, materials, telecommunications, utilities) plus the 19 industry groups from the six other sectors.

@page_break@Occasionally checking the long-term prices of the S&P/TSX’s 23 subindices is a manageable task compared with scouring the price action of scores of individual stocks.

Before the present TSX index system started, the previous TSX index had 14 sector divisions. Three-year price changes among them produced useful signals from the 1950s into the 1990s. IE