end of the year thoughts (iv)

One of the deep, dark secrets of active equity portfolio management, is that almost no professional manager does better than an index fund. That’s even before subtracting the fees clients pay for this “service.”

As it turns out, I had a twenty year stretch as a global equity pm, during which I generally outperformed my index (with the occasional clunker year). But I was an outlier. And I never managed more than a couple of billion dollars, which meant I had lots of flexibility in what I could hold than managers of mega-portfolios. I also spent less of my time interacting with the people who hired me, because there were fewer of them.

Who outperforms, then? If professional managers in the aggregate are (mild) losers to the S&P 500 year after year, someone else must do better. But who? My belief is that it’s individual investors like you and me. But this is a story for another day.

The point I want to make today is that owning an index fund isn’t a bad thing. In fact, odds are that you’ll beat most professionals, and pay lower fees, doing so.

It seems to me that a superior strategy is to hold, say, 80% of your equity savings in index funds or ETFs and the rest in a few individual stocks or sector ETFs that there’s some reason to believe you know more about than the average holder. This involves work. Thinking about your companies and their competitors, reading the SEC filings and company press releases, studying the relevant industry, using the products, if you can… If you do this with one or two, or a few, stocks, chances are you’ll do better than the typical pm–who probably doesn’t do much of this. If you find this boring, on the other hand, stick with index products.

I think the first half of 2023 will be an especially problematic time for world stock markets. If this is right, it’s an argument for ticking closer than normal to an index.

It’s not that I expect anything like the series of earthshaking events that dominated 2022–Trump’s attempt to overthrow the US government, the invasion of Ukraine, the dual China problems of an imploding property sector and rampant covid, the sharp rise in interest rates in most of the world as covid-related economic stimulus began to be reversed.

The big issue I see is exemplified by Morgan Stanley’s view that the S&P 500 could decline another 25% in the first half as disappointing corporate results from 2022 are announced–mostly during 1Q23.

Two aspects to this conclusion, as I see things:

–the pandemic ended pretty much all at once during the first half of 2022. This caught most publicly-traded companies by surprise. They had been loading up on raw materials and finished goods they could grab, double- and triple-ordering and being willing to pay very high prices, on the idea that the pandemic would continue for a much longer time. Think: used cars, for example, or mid-range large screen TVs.

What do companies do in a case like this? They say as little as possible initially, and hope to be able to sell as much as possible of the (now hugely bloated) excess inventories. But they can’t do this forever. Typically, at the end of the reporting year–December, or January for most retailers–they’ll come clean (or clean-ish) and write their inventories down to fair market value (there are limits to what they can do, but this is a minor point). Morgan Stanley appears to think that this + weak holiday sales mean the coming reporting season will be particularly ugly.

–in the world I grew up in as an investor 20-30 years ago, armies of securities analysts working for investment managers and for brokers would have been hard at work trying to figure out the magnitude of the bad news. And stocks would begin to decline–far in advance of company announcements–as analysts’ results became known.

Some of this is certainly happening now. Look at Carvana (CVNA), now trading at 1.5%!!! of its mid-2021 high. …or KMX (CarMax) at 42% of its high. Morgan Stanley, however, seems to think that the main market downdraft is still to come. Trading bots, trained to react to earnings results, will drive the market down sharply as full-year 2022 results are announced in late winter.

In my experience, a bull market ends up factoring into current prices more than all the good news that the coming year could possibly bring, and a bear market will discount the same bad news over and over again. We’ll know the bear market is over when companies announce bad news and the stocks don’t go down.

Personally, I think we’re very close to this final bear market stage, if we’re not there already. But I’m certainly not willing to bet that I’m correct. What I’m actually doing now is combing through what I hold, to weed out the names I think are the weakest.

More next week. Happy New Year!!

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