Conventional wisdom among equity portfolio managers is that it’s relatively easy (maybe easier) to get outperformance vs. an index during a bear market than a bull market.
In a down market, the companies that are in the most highly cyclical industries–like manufacturing, construction, property, or consumer durables–and the firms that are the most structurally fragile (operations or finances) get pummeled the worst. So a very simple strategy–stay away from them–usually works well. You may lose money, but it will be nothing like what will happen to people in the “bad” areas.
In the typical up market, however, almost everything goes up. And sometimes the weakest companies go up the most, at least for a while (see my post on the behavior of “near-death experiences” in a bull market). There are two reasons I can see for this “rising tide” behavior:
1. when managers of the largest portfolios realize that the worst is over for stocks and a new bull market has begun, their first priority is to work down their cash reserves and become fully invested as fast as possible. The best way to do this is to buy shares of the most liquid (read: largest capitalization) companies. You may not be in a first-class seat on the bull market train this way, but at least you won’t be left standing on the platform watching it pull out of the station. Basically, then, for a while the main stocks in most industries go up.
(An arcane footnote: Sometimes investors are “trapped” in small cap stocks if liquidity dries up. There just isn’t enough volume to sell an institutional-sized position. If you show even, say, 10% of what you own on the market, even if you take precautions to do this slowly and as secretly (that could be an inside joke) as possible, professional traders will soon work out what you’re doing. They’ll assume (correctly) that you want to sell all you hold, and the stock will crater. Until the market turns, your best (and probably only) option is to continue to hold. Anyway, when a bull phase begins, the market in stocks like this will begin to clear. But their first move may be to go down on high volume as formerly trapped investors finally escape. This is usually a great chance to buy.)
2. The market is typically rapidly rotational, both from industry group to industry group and from high-quality to low-quality within industries.
Why is this? “Don’t chase!!” is one of the first lessons any rookie portfolio manager learns. Don’t buy stocks that have already had strong upward movements. What should you do instead? Reconcile yourself to the fact that you’ve missed the opportunity in a certain area. Sit down and figure out what is likely to move next and buy that. Don’t help your more astute (at least for now) rival exit from positions whose run of outperformance is almost over. If all the biggest names in an attractive industry have run already but the smaller haven’t, buy the smaller. If the most leveraged have run but the less leveraged haven’t… Again, given a little time almost everything goes up.
Another crosscurrent: the next step for the managers in paragraph 1. who have succeeded in becoming fully invested is to reshape their portfolios into what they believe is a more advantageous position. At first, they’ve bought big stocks across the board. Now, they start to shift some of that money into smaller, harder-to-buy, names. Their action creates a drag on stocks whose previous good performance has partly been due to their buying and gives a lift to shares they are in the process of purchasing.
For these reasons, the argument goes, a bull market resembles a clearance sale at a department store. There are few trends, if you can call them that, that persist for more than a couple of months. This makes it impossible to position a portfolio so that it achieves consistent outperformance.
This time’s an exception
So far in 2009, the S&P 500 is up 25.1%. Looking at the index sectors, however, shows very clear patterns. For example:
Consumer discretionary + 34.2%.
On the other hand,
The performance differential has been in the same direction but even to a greater extreme since the market bottom in March. What I’ve found really striking about this bull market so far is the sharp separation between winning and losing sectors. The “bad” sectors have been especially bad. There have been few periods of more than a couple of weeks where they have shown any signs of relative strength.
How can this time be so different?
1. individual investor behavior. According to Investment Company Institute (the fund management trade association) data, individuals have made massive new commitments of money to bond funds since the stock market bottom, while taking a neutral/negative stance toward domestic stocks. This despite record low bond yields. So it has been bond managers, not stock managers, who have been scrambling to get new inflows of money invested quickly. Domestic stock managers are more than likely eyeing weak positions as possible sells to meet redemptions.
2. “pent-up” demand is missing. US economic upturns have traditionally been led by vigorous consumer spending, even in advance of new job creation. Outlays have been focused on–although not limited to–housing-related areas, construction and consumer durables. The current recession has occurred at the end of, and because of worries about further financing of, a period of massive over-buying in all these areas. The epicenter of the problems has also, unusually, been the US. As a result, we haven’t seen enough demand for second- and third-tier firms to prosper. And the lack of consumer power has exposed structural problems in some areas that would go unnoticed in a more upbeat environment.
What do I think?
On a personal level, I’m not too disturbed so far by the US stock market’s break with the patterns of the past, since the stocks and mutual funds I hold have turned out to generally have been in the right places. On the other hand, it puts me somewhat on edge to realize that we are sailing in uncharted waters, where the maps of history are not of great assistance.
Actually, now that I’ve written it, I recognize that my last sentence is not quite correct. The US market–world markets, in fact–have been marked over the past 15 years or so by broad conceptual movements that have gone to great excess and then reversed themselves. There were the internet stocks of the second half of the Nineties, followed by the massive updraft of value issues just after the turn of the century, and then the housing/financial boom.
If there’s a theme to what’s going on now, it’s probably a negative one–safe havens from the US/UK financial meltdown. I don’t think we’re in anything close to bubble territory, though.
I’m perplexed by the flight to bonds, mostly because rates are so low. I kind of surprised myself by making my recent argument that WMT, with a current dividend yield higher than a five-year Treasury bond (note?), is a much better alternative than a Treasury security. Why is no one–other than Warren Buffett, whose portfolios have added large amounts of WMT recently–interested?
While it’s true that during the Lost Decade of the Nineties in Japan, the dividend yield on the Topix index was above the JGB coupon for years and years without any interest in stocks by domestic investors, they all knew that Japanese companies are run for employees, not shareholders, and one bad day in the market could wipe out their yield advantage. The extensive cost-cutting and continuing layoffs surely show that there’s no comparison between the two situations.
Three useful ideas…
…not just the musings of the section above.
I think that at some time, utilities, telecom staples and health care will have their day in the sun. But if I had to guess, that won’t be until the Fed begins to raise interest rates late next year. So there’s no rush.
Sometimes, the market makes a big-concept anticipatory move up or down and then pauses as it waits for events and begins to sort out the wheat from the chaff. We may be in that second situation now. If so, the market may do no more than provide a stable platform from which strong-earnings companies launch themselves higher.
In the US, we’re used to being the middle ring of the circus. This time, it’s more like we’re on the sidelines selling popcorn. So if we focus only on the internal domestic economic situation, we may not be able to see the important forces of global economic growth emanating from abroad.