I’ve just updated my Keeping Score page for August.
Tag Archives: investment performance
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.
Value Line: why mechanical systems stop working
Sam Eisenstadt of Value Line created a famous computer-driven stock ranking system that worked fabulously for about a quarter century. Then it stopped working. Why?
1. Any economic system is dynamic, not static. When an innovation happens, it spurs changes in all sorts of other systematic variables. When a competitor introduces a new product into a market, rivals don’t simply watch their market share erode. They launch new products themselves, ranging from simple knockoffs of the original innovation to genuinely new, but different, products of their own.
To the extent that “me too” products proliferate, the value/power of the initial innovation is eroded. In the case of Value Line, post-ERISA, rival money managers poached Value Line IT people to create duplicate systems for themselves. In fact, a number of very successful value-oriented money managers in the 1970s-1980s were driven, so far as I can see, almost exclusively by their VL ranking system knockoffs.
The fact that many professionals began to act on the system’s predictions–in large size and as soon as the predictions were made–began to blunt the effect of the system. It tended to make subsequent outperformance smaller in degree and duration.
In short, the Value Line system changed the world …and then the world began to catch up.
2. The Value Line system is based on an extensive analysis of historical data. That was okay when computing power was expensive and when (future-oriented) stock market derivatives were few and far between. This was also before ERISA turned money management from a backwater into a gigantic business, that is, before brokerage houses and money managers built large staffs of securities analysts churning out predictions of future earnings.
The result of these changes was to reorient Wall Street away from historical earnings to studying–and buying and selling based on–future earnings estimates. When the actual numbers came out, the market had already reacted. Not always, but most of the time.
3. The system has, in my view, a number of quirks, which I’ll just state without elaboration.
–It’s biased toward smaller stocks, which is one reason the VL system did so well in the 1970s.
–I think there’s a semi-permanent underclass of 5-ranked stocks, which makes the 1 vs. 5 comparison less relevant than, say, 1s vs. the S&P 500.
–The system is bad at turning points in the economy, activity either decelerates or accelerates sharply. In today’s world, investors react to macroeconomic news far in advance of when corporate earnings reflect such changes.
–It works better in down markets, where investors cling closer to reported earnings, than in up.
could the VL system start to work again?
Maybe. Sam Eisenstadt is a shrewd guy, after all. Much of the Wall Street information gathering apparatus has been dismantled during Great Recession-induced cost cutting. We’re unlikely, I think, to experience another decade of macroeconomic and stock market disruption on the scale of the past ten years (at least, I hope we won’t). So conditions for a system like VL’s to work look to be better than they’ve been in a long time.
The biggest issue I can see is that computing power is no longer expensive. Most of us could do something like what VL does on our home computers. I doubt many of us are going to take the trouble, though.
US banks since the repeal of Glass Steagall
In the 1930s, Congress passed a series of laws, collectively known as Glass Steagall, that barred commercial banks from engaging in brokerage/investment banking activities. The rationale: the linking of banking and brokerage in one company had spawned abuses that had a big hand in causing the Great Depression.
Fast-forward to the late 1990s. Glass Steagall was gradually rolled back and then discarded. The rationale advanced by bank lobbyists in Washington? …commercial banks were older, wiser and better-managed. Banks also needed to expand their size and activities to compete successfully with the “universal” banks of the EU, which already were allowed to combine commercial and investment banking under one roof.
How’s that been working for us?
Well, in the decade-plus since, the new domestic “universal” banks:
–destroyed the mortgage market through wild speculative lending and widespread misrepresentation of the poor character of the mortgages they subsequently bundled up and sold off to others. Voilà! …the Great Recession. (Perversely, though, the American banks caused near-fatal wounds to their EU rivals, who were the eventual “dumb money” buyers of much of the sketchy mortgage-backed paper.)
–last year, regulators began investigating the big banks for illegally colluding to manipulate short-term interest rates through LIBOR (the London Interbank Offered Rate).
–recently, a similar investigation has been opened up to look at illegal bank collusion in foreign currency markets. According to the Wall Street Journal, so many bank senior currency traders have been suspended that too few honest traders (not an oxymoron, but close) may be left for global currency trading to function smoothly.
–reportedly, more investigations will be opened for other bank commodities trading, notably oil.
Wow! I find this all hard to take in. I have several reactions.
The first is that, either by accident or design, these investigations are only being launched after the worst of the financial crisis is over–meaning that the banks can withstand the financial and reputational shocks these inquiries are causing without triggering panic withdrawals by depositors.
The downsizing of the banks, now underway, probably still has a long way to go. The best and the brightest younger minds will search for jobs elsewhere, fearing the industry taint may be deep and more enduring.
Despite the financial industry’s enormous political clout in Washington, continuing scandals argue that further legal restrictions on banks’ activities are probably inevitable.
This all suggests to me that big money-center banks will be uninteresting investments for a considerable time to come.
As a citizen, the banking mess is appalling.
As an investor, the current situation suits me fine. I’ve never understood banks, I’ve never been willing to do the work needed to see what’s going on underneath the covers–although I’m sure I would never have guessed the extent of the criminality they’ve been involved in.
In a practical sense, the banking scandals mean I can focus my attention on IT and Consumer Discretionary as sources for individual stock ideas, without worrying that Financials will move to the head of the pack.
What makes this important is that Financials account for a big chunk of the index.
As the S&P 500 stands today, the largest sector by market weight is IT at 17.7% of the index. Financials (16%) is second. Healthcare is #3 (13%). Consumer Discretionary (12.5%) is #4. Together, these four sectors make up about half the index. Being able to ignore/underweight one of them with a high degree of confidence is a big deal.
Keeping Score for October 2013
I’ve just updated the Keeping Score page. Hope Halloween went well.