stocks in lockstep: what’s going on

US stocks have been travelling more or less in a herd–with, statistically speaking,  little to distinguish he performance of one individual issue from the next.  This sort of thing often happens at the start of a bull market, not almost five years in.

In other posts I’ve described 2013 as a year of “normalization” of the stock market.  During bear markets, fearful investors shift their focus from buying stocks based on anticipated earnings a year or so in the future to concentrating on reacting to actual earnings as they’re released.  Normally, six months or so into a recovery investors begin to reverse this stance and begin to value stocks based on (higher) future earnings rather than historicals.  During this period the market’s price earnings multiple expands.

After the Great Recession, that didn’t happen until 2013.  It took almost four years, plus two years of Treasury security losses–and the expectation that the returns from fixed income would remain negligible for a considerable time to come–for many investors to be willing to take the risk of investing in stocks again.

I think three points are important:

1.  It seems to me that any cyclical asset allocation shift away from bonds has already run its course.  Individual Baby Boomers, who hold much of the wealth in the US, have a distinct age-appropriate preference for income-generating investments. So they’re going to continue to hold some bonds, no matter how poorly they perform.   Also, in what I expect will be a flattish year for stocks, there will be little pain-induced motivation from equity gains to make further asset allocation shifts.

In addition, institutional investors appear to have reached their maximum allowable allocation to equities after a year in which the performance differential between stocks and bonds has been massive.  They may actually be forced to sell equities–although my sense is the reason institutions continue to hire hedge funds (despite a decade of continuous horrific underperformance of traditional managers) is to get around their investment guidelines by reclassifying equity exposure as “alternative” investments.

–I’ve believed for some time that the Great Recession shattered individuals’ belief in the merits of actively managed equity mutual funds.  A shift to index products, ETFs or mutual funds, would explain why stocks have risen across the board.  True, many hedge funds are run by former traders who lack the skill to analyze individual stocks, so they’re index-only players, too.  But that’s been true for years.  Their behavior doesn’t explain why there was less differentiation among stocks in 2013 than in 2010 or 2011.

–Last year’s homogeneity sets up a potential bonanza for stock pickers this year.  There may be some segments of the stock market–the 100 largest names by market cap?  the top 200?– where the asset allocation mindset will continue to dominate, however.  My guess is it will be better to look among smaller names and among stocks that have short histories being publicly traded.  But the important thing for now is to pay attention to the market’s behavior as we get through the quirks of January and into a more normal market next month.


why stocks moving in lockstep in 2013 was unusual

Speaking in very general terms, the stock market is the place where the hopes and fears of investors meet the objective characteristics of publicly traded companies and express themselves in the prices and price movement of little pieces of paper.  In today’s world, it’s really the movement of electronic impulses.

More prosaically, supply and demand meet and express themselves in stock prices.

Investors are a diverse lot.  We range from day traders to those with five-year horizons.  There are institutions and individuals, professionals and amateurs, market timers and the always fully invested, the purely rational (a rare breed) and the highly emotional, the risk averse and even a few risk takers.  (A pedantic note:  a risk taker transacts in order to acquire risk;  he doesn’t care about return.  A risk averse person transacts when he sees a favorable risk/reward relationship.  What counts as favorable can very widely.)

Despite this diversity, there are recognizable patterns to stock investment.  One of them is the way stocks behave at different points in the business cycle.

–stocks in the US tend to start to rise, often very sharply, about six months before the business cycle begins to turn up

–once investors who have been sitting with cash on the sidelines realize that the market has turned, they start to shift that idle cash into stocks.  They may do so by buying stock index futures, or they may buy individual stocks–or both.  In any event, their main goal is to get a lot of money on the train as fast as possible.  Getting the best possible seat can come later.

Not every investor is like this.  But there are enough trying to get very large amounts of money reallocated into stocks at the most favorable prices that buying is pretty much across the board.

During this period, stocks are relatively closely correlated.

–as this initial surge into the market subsides, the market gradually shifts toward differentiating among stocks based on their anticipated growth rates and on their pricing.

In other words, as the business cycle matures, stocks become less correlated with each other.  The style-agnostic shift from value stocks to secular growth names.

what makes 2013 strange

2013 was the fifth year of the bull market.  Yet stocks were more highly correlated with each other than they were in 2009 or 2010.  Given the way the stock market usually works, the opposite should have been the case.

Tomorrow:  what I think is going on.

stocks were “unusually highly correlated” last year–meaning? implications?

A number of brokers have pointed out in their yearend reviews of the US stock market that stocks were unusually highly correlated with one another last year.  What does this mean?

Think of a stock as an abstract thing, as a bundle of different economic attributes or characteristics that you get when you buy it.  Some of these attributes–like that you get an ownership interest in a corporation that aims to make continually growing profits–are common to all stocks.  Others–that the underlying company you own an equity interest in makes yoga pants, mines gold, or sells online advertising, and grows faster/slower than most–are specific to that stock.

The “highly correlated” observation means that, much more than usual, what counted in 2013 was the fact the thing you own is a stock; its individual characteristics didn’t make much difference.  Check out my Keeping Score for December 2013 to see how closely aligned the performance of various industry groups was last year.

Note how clustered together the various sectors are around the S&P.  In simple terms, an investor got +30% just for owning the S&P 500.  He got an extra 8 percentage points for selecting Healthcare, and he lost 7 if he picked Energy.  But neither decision meant anything close to as much as just being in stocks.

Yes, there were two truly poisonous sectors, Telecom and Utilities, which just barely made it into the plus column for 2013.  These two sectors together make up only about 5% of the S&P, however.  So from a statistician’s point of view, they’re irrelevant.  That’s cold comfort for someone who bet the farm on either sector last year, although I think you’ve got to admit that being absent from 95% of the market is an extremely risky thing to do.

Tomorrow:  why is the 2013 outcome is strange.

Shaping a portfolio for 2014 (v): putting the pieces together

Late March of 2014 will mark the end of year five and the beginning of year six since the bottoming of world stock markets after the 2007-2008 equity collapse.  The second half of the year will mark the same low point for world economies.

Given the very strong stock market performance of 2013, as well as the length of time since the market bottom, one’s first instinct for 2014 is to be cautious.  More than that, based on past market patterns, common sense says that in year six of expansion one should be on the alert for the next possible downturn.

Nevertheless, I think there are several strong positive elements in the current stock market situation:

–world economies are likely to continue to expand in 2014.  The rate of positive change will be strongest in the EU, although this is also an observation about numbers close to zero.  China appears to be over its regime-change slowdown.  Importantly, the new administration is trying to make a structural shift away from export-oriented growth toward domestic consumption, implying that the usual yardsticks investors use to measure China may not be as reliable as in the past.  The US continues to be surprisingly resilient.

–interest rates will stay ultra-low for at least the next couple of years.

–at 16x projected earnings of $110, the PE on the S&P 500 is reasonable.  Based on the behavior of securities markets over all but the first couple of years of my career, a PE of 16 would be consistent with a long Treasury yield of around 6%.  In other words, today’s market PE already factors in all the interest rate tightening that will happen over the coming rate normalization cycle.

My bottom line:

–stocks will have a typical up year in 2014, driven by advancing earnings, of about +7%-8%.

–growth outside the US will likely be better than inside the US for the first time in several years, meaning portfolios should move away from a domestic-only bias.

–stock selection in the EU is the only really problematic issue I see.  It’s unclear whether strength will mostly be reflected in upward movement of stock prices in euros or in an advance of the euro vs. the dollar.  In the latter case, domestic EU-oriented stocks will be the stars and export-oriented/multinational names, which have been serial outperformers since 2009, will lag significantly (this is my basic assumption).  In the former, I think domestic outperformance will still be there, but will be less crucial to stock selection.

–growth names usually outperform their value counterparts as the business cycle matures.  That’s because the surge of extra consumption deferred during recession, and which speeds the profit growth of cyclical stocks, abates.  So secular growth stocks show superior earnings expansion.  I think this will prove true again in 2014.

–this time, however, the dividing line between outperformer and underperformer is probably going to be south of +10%.  So high dividend-yielding stocks, which have been relatively crushed this year (read:  up maybe 10% in a market that’s up 30%), have a chance to redeem themselves in 2014.  I’ve already suggested MSFT as a possibility.

–short-term volatility could be high.  My guess is that any short-term downdrafts will be triggered by (crazy, in my view) worries about Fed tapering.  Generally speaking, though, stocks rarely go sideways for extended periods of time.  If I’m right that the upside for the S&P is less than/around 10%, any advance creates a situation where stocks, at least temporarily, have only one way to go.  On the other hand, low interest rates + good profit growth will limit possible downside.


Shaping a portfolio for 2014 (iv): interest rates

the current situation in the US

The first time I visited Taiwan, in 1985, I was struck by the presence of armed soldiers–bayoneted rifles at the ready–at the toll booths on the highways.  It turned out Taiwan had been in an official state of emergency, guarding against possible invasion from the mainland, for a very long time.  The reality of the 1980s, however, was that the Peoples Liberation Army didn’t have enough boats to launch an invasion.  Also, what trucks they had would have broken down on the way to the ports, leaving would-be invaders scattered in small groups around the countryside and forced to hitchhike back to their bases.

Monetary policy in the US is a lot like the Taiwanese state of emergency–except that the Fed, through Quantitative Easing, continues to issue its metaphorical soldiers ever-longer bayonets and more bullets.

It wants to stop doing that, by “tapering,” or decreasing the rate at which it pumps extra amounts of money into the US economy.  It doesn’t want to roll back the state of emergency–by raising short-term interest rates from the current zero to a “normal” 4% or so–for at least two years.  The process of normalization itself will presumably take several years to complete.

economic consequences

The current situation is great for anyone who wants to borrow money.  It’s horrible for savers (read: senior citizens).

The Fed is not maintaining its state of emergency because it thinks the economy is too weak to tolerate higher rates.  Rather, its “dual mandate” from Congress legally binds it to try to fight the current high level of unemployment, a task that normally falls to fiscal policy from the administration and Congress.

The failure of fiscal policy–normally public works construction + worker retraining–means that financial incentives are skewed in a potentially harmful way.  Also, the Fed has nothing left in the tank to respond to any new emergency that may arise before rates are back up to normal.  We’d have to depend on the administration and Congress.  But that’s the world we live in.

investment implications

Two opposing forces:

–the Fed has no intention of raising rates for a long while, but

–raising, earlier this year, the possibility of starting to slowly wean the economy from ever-accelerating expansion of the money supply signaled that the thirty-some year era of continually looser money policy–with its accompanying ever-lower interest rates, ever-higher bond prices–is over.  The next move, when it comes, is a reversal of form.  Higher rates, lower bonds.

My take:

–in past times of post-crisis rate normalization, bonds have gone down, stocks have gone sideways to up

–historically, a turn in the price of any commodity comes in two phases.  The first is anticipatory, as the market perceives a change is likely.  That’s followed by a volatile sideways movement, which ends when the commodity begins to rise in price.  That’s my best guess of what will happen with interest rates and bond prices–trendless volatility.

–the present crop of professional traders don’t strike me as being particularly astute students of history.  Few will have actually experienced during their professional careers an extended period of Fed tightening.  No one has seen a Fed tightening of the peculiar type we will be undergoing in coming years.

We’ve already seen the anticipatory move in bond prices.  The Fed thought it was irrational enough that it spent months unruffling traders’ feathers.  It’s possible that next year the trading community will make the ride bumpier than it needs to be.