Yesterday I wrote about the view of Goldman equity strategist David Kostin that, on a capital changes basis (i.e. , not counting dividends), the US stock market will be flat over the coming 12 months and will edge higher at only about a 2% annual rate for at least several years after. Collecting dividends will be a major source of total returns. In fact, if the reason for this sub-par showing (by historical standards) is that earnings will grow but price earnings multiples will contract as interest rates rise (I’ve only read a bare-bones summary of Mr. Kostin’s view), then dividends may be the major source of returns.
Let’s suppose Mr. Kostin is right. What does this mean for investors?
1. Losing stocks will be devastating. Large losses always hurt more than large gains. But a strongly rising market tends to act somewhat like a safety net to cushion the fall, as well as offering a chance to catch the next shooting star to make up for the mistake. A flat market is less forgiving, and will presumably offer fewer chances to recoup from losses.
2. One or two winners will probably be enough to make a portfolio manager’s year. Careful securities analysis will be rewarded with outperformance, provided a manager can avoid having big losers. Again, this is nothing new–although the idea that having a ton of stocks you spend only a little about is not as good a strategy as having a few you know inside out has eluded academics until recently.
3. Trading stocks, aka market timing–a tactic reviled in investment folklore–probably becomes more important as a source of performance (maybe this is why GS is content to let Mr. Kostin publish). This will be doubly so for non-taxable accounts.
If we truly believe the major trend is sideways, buying and selling portions of positions based on valuation–especially in the case of stable, mature companies–becomes a more attractive strategy. This is sort of like bunting for a base hit–you need a lot of successes to score a run. But it may be the only way to get on the board if the market is throwing blanks.
4. For institutions, trading through derivatives–maybe in the same fashion big bond funds operate–would provide liquidity and speed that gigantic portfolios can’t get otherwise. Custom-tailored OTC derivatives may be the most preferred. Not for you and me, but probably for the largest money management houses. Great for brokers’ profits, too.