An important thing that doesn’t get talked about much is that the stock market is just that, a marketplace–one where the hopes and fears of investors meet the objective characteristics of listed companies and express their interaction in stock prices.

In a typical optimistic market, investors are willing to discount (Wall Street jargon for “factor into today’s stock price”) potential earning power for a given company as much as two or three years in the future. In the wild, covid-driven, zero-interest-rate market of 2020-early 2021, investors have been willing to discount profits considerably farther ahead than that. Potential investors may also let their imaginations run a bit into overdrive as to how good those future earnings might be and/or how likely the best case scenario is to occur.

In contrast, in a nervous market like the one we’re in now, it’s possible that the balance sheet and income statement characteristics of the companies don’t change that much (in the current case, my guess is that overall S&P earnings come out about the same as rates move higher but that the winners and losers shift a bit). What certainly changes, however, is that investors undergo a dramatic mood change. They pull in their horns. They are no longer willing to discount earnings several years in the future; in the most ugly markets I’ve lived through, investors won’t pay for any future earnings, even next week’s. They shift from dreaming about how good things might be to focusing on the most conservative outlook. Stock selection shades away from tomorrow’s potential winners to more mature, steady income generators.

This may just be me, but it seems that over the past decade or so many professional investors have shifted away from being anticipatory to being reactive. That is, they’ve played down the traditional emphasis on detailed study of individual companies/industries, with an eye to uncovering those whose profits will likely significantly exceed consensus estimates. Instead, they now focus on swift, AI-driven, response to news reports–either company-specific or general economic–that appear to have a bearing on future profit potential. Why do this? …it’s cheaper than having a staff of seasoned analysts and clients think the “objectivity” of computers gives them a better defense if their chosen manager underperforms.

This would explain why the selling we’re now experiencing seems so relentless and so willing to push prices down significantly. Whether I’m right or not, selling does seem to me to be both aggressive and not particularly selective. The result may ultimately be the creation of a new class of “value” stocks–cash-rich, earnings-poor companies that have come to market during the pandemic.

My guess, for what it’s worth, is that the flood of selling that greeted the new year has come to an end for now. I don’t know whether this signals the worst is over (my guess is that it isn’t), but I do think it means the market feels that overall prices have fallen too far, too fast.

I think an important thing to do now is to look through the parts of our portfolios that have suffered the brunt of the selling and separate the stocks that are bouncing as the overall market recovers from those that aren’t. Although there are no flat-out rules, I’ve always thought of the latter group as a significant cause for concern. Continuing weakness typically implies that there’s something specific to the company–apart from sector rotation or other general market happenings–and something that I haven’t yet realized that’s behind the lack of strength.

This doesn’t mean one should sell. After all, a big key to success is to know a few stocks better than the market does. But I think it does mean needing to double-check to make sure there isn’t any major negative I may have overlooked.

The Wall Street Journal published an article yesterday reporting on the 2021 investment performance of actively managed funds, both traditional mutual funds and etfs, focused on the US stock market. Their median return was +22.5%. As far as I can tell, this figure is a total return (meaning including a dividend yield of about 1,3%), and after management fees and expenses. In today’s world, the dividend yield and fees more or less cancel one another out, so for a rough-and-ready assessment, the headline number for fund performance is comparable to the capital changes performance of the index. The latter is what I use on my Keeping Score page.

The S&P 500 capital changes return for 2021 was 26.9%. In other words, the average fund underperformed the S&P by about 4.5% last year. My impression is that this is an unusually weak performance by active managers, but my quick Google search to try to confirm this turned up a ton of ads and no information other than that active funds were crushed during the first half of 2020. The figures I’m familiar with show that only about 10% of active managers are able to match the S&P performance after fees and expenses.

Despite their history of ineptitude, active funds collected $113.1 billion in new assets last year. Somewhat stranger, to my mind, international funds, which give one exposure to the senescent economies of Japan and Europe, took in $193.2 billion. To me, the oddest of all is that bond funds added $587.1 billion in new money. That’s even though the Lipper universe of intermediate-term bond funds lost -1.3% in 2021 and will likely be in the red again in 2022 as interest rates rise.

The most intriguing question to me is not why investors continue to pour money into underperforming vehicles, but who the outperformers are. It’s certainly not hedge funds, whose last period of outstripping more conventional investing came close to two decades ago. Some money clearly goes to brokerage intermediaries. But can that amount to 4%+ of assets? My guess is no. This seems to imply that the big net winners are people like you and me.

I saw a survey of fixed income investors earlier today that indicated the consensus is shifting from expecting three 0.25% increases in the Fed Funds rate during 2002 to four, one per quarter. Given that today’s overnight borrowing rate is effectively zero, this suggests a Fed Funds rate of 1.00% by yearend. If we were to make the much-too-simple assumption that rates would rise in lock step along the yield curve, this would imply a 10-year Treasury note at 2.75% in December.

Looking at rates from a different perspective, if we think the Fed’s ultimate goal is to have 2.0% inflation and a 100bp real yield on Treasuries, then the end point for the 10-year in the tightening/restoration of normal cycle we’re now starting would be a 3.0% yield.

At this juncture, the more important thing is not whether my figures are any more than generally close to accurate, but rather that interest rate policy has turned from a tailwind into a headwind for the stock market–and that things will stay this way for a considerable period of time. We’re at the beginning of the normalization process, not the end.

The immediate response of the stock market to rising interest rates is that the overall PE multiple contracts. The major offset to this is that earnings generally turn out to be stronger than expected, countering at least part of the downward pressure. Two, maybe three, issues, though. Perhaps the most important for us now is that the earnings are only reported quarterly, so the relief only comes through with a lag. Second, the companies that will show the strongest earnings growth aren’t necessarily the companies that have been the market darlings of the past year or two. Finally, I think the market tone will be dictated to a large degree by AI analyzing and reacting to the financial press. The people creating this content are relatively inexperienced and tend to reflect yesterday’s developments rather than anticipating tomorrow’s. I think this is likely to lengthen the time the market will spend discounting the fact of higher interest rates.

more on Monday

The old school stock market I spent most of my career as an equity portfolio manager in had two characteristics: it was anticipatory and it was granular.

Armies of securities analysts, employed both by investment managers and by brokerage houses, pored over company financials, met regularly with managements–in public meetings sponsored by the local security analyst society, in private or by phone–to discuss operations, and, ultimately, to construct elaborate spreadsheets, from which they made informed earnings estimates. For a growth investor, the goal was to buy stock in companies where one’s spreadsheets indicated earnings would be much better than the consensus realized, and for longer than the consensus dreamed possible.

In the 1990s, investment managers realized they could save money if they eliminated in-house staffs and relied instead on research created by brokerage houses. During the 2008-09 financial crisis, the big investment banks laid off virtually all their highly-paid veteran analysts and replaced them with neophytes, on the idea that trading rather than research is their bread and butter

All in all, these developments are a big plus for individual investors like you and me, I think. Yes, some present brokerage researchers are still very good. But they’re closer to polished high school athletes than Jacob deGrom and Aaron Rodgers. So it’s much easier today for us to know more than the market does by focusing on a few areas or companies we’re interested in.

What to professionals do today? Given that I haven’t worked in the industry for a decade and a half, I don’t know for sure. Looking at the rhythms of the markets, however, I’m convinced today’s Wall Street is reactive, not anticipatory, and is focused on broad economic factors, not the nuts and bolts of individual companies.

By reactive, I mean professionals now concentrate on making an immediate, strong, presumably computer-driven, response to news developments. A good example, I think, is the stock and bond market plunges that followed Monday’s release of minutes of the December Fed meeting where the possibility was discussed that it would be raising interest rates sooner than expected. Hints of this had been floating around for a while, but hard news seems to have triggered the selling.

The decision about what to sell the most aggressively seems to me to be shaped by one form or another of factor analysis, which has been used in financial markets since at least the 1980s. The idea is to describe a given stock as a bundle of characteristics, or factors, based on a statistical analysis of its past behavior–and then trade the (smaller and simpler to figure out) set of factors rather than the big universe of stocks. Factors can be very traditional, like financial leverage or profitability. Others can be highly specific. One used early on, for example, is “sensitivity to changes in the oil price.” Loss-making tech companies might be another, more contemporary one.

Factor systems have a checkered history it terms of creating outperformance. They have two advantages, though. They’re cheaper and easier to maintain than hiring/training a bunch of human securities analysts. Also, potential clients feel much more comfortable buying “objective,” computer-driven systematic investment schemes than relying on a potentially quirky human. A much better excuse if things turn out badly.

My experience is that factor systems tend to overreact. This characteristic is amplified by the twitchy nature of today’s trend toward ultra-fast reaction to news. Two implications:

–there will always be opportunities to upgrade holdings during a downdraft like the one we’re in now, and

–not so relevant for now, but we should also arguably be more willing to take partial profits on a stock that’s going through the roof