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Investor’s CornerByGudritz CFA
Principal
Front Street Investment Management LLC
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Ever since the financial crises in 2008, the stock market has been moving up and down more on macro economic and political news and concerns than on individual company fundamentals. The market is not rewarding good micro-analytic stock picking skills as most stocks rise and fall in lockstep with the market. I think that will change, but it will probably take some time.
According to research done by Barclays Capital, increasing macro economic and political concerns in the stock market tend to increase the correlation of stocks to their respective market indices. The “big picture” issues that affect all companies tend to overwhelm company-specific news in the market, which causes most stock prices to react in the same way.
This phenomenon most commonly occurs during and shortly after a recession and bear market. But it can also happen around significant economic and political events like wars and sovereign financial crises.
The opposite is true when the economy is recovering and expanding. During these “good times” macro issues take a back seat to individual company fundamentals and stock prices are far less correlated to the index. This is when good stock pickers are able to distinguish themselves.
We began Front Street Investment Management in 2003 during a period of low correlation in the stock market and were able to put our micro analytical skills to good use. Our efforts were well rewarded. Our clients’ equity-only portfolios significantly outperformed the S&P 500 Index from 2003 through 2006.
Since the spring of 2008, we have devoted the majority of our time to trying to understand what is going on in the economy in the U.S. as well as in Europe and Asia. The Great Recession was not a typical business cycle recession caused by too much inventory. The circumstances were more like what happened in the Great Depression of the 1930s.
It is obvious from watching our government leaders and the Federal Reserve that no one really knows the best way to deal with an economy suffering from the effects of credit contraction and falling asset prices (real estate). Their actions have been based more on theory than past experience. And as they search for answers more people are losing their homes and others still can’t find a decent job.
This has brought about a severe lack of confidence for both Wall Street as well as Main Street. People have become much more conservative with how they spend and save as well as invest their money. Money has been flowing out of equity mutual funds and into shorter-maturity bond funds. As a result, traders and hedge funds have taken over the stock market and macro issues continue to determine the day-to-day direction of the market. The correlations among stocks are high once again and good stock picking, in general, is not being rewarded.
There are also other factors besides macro forces within the stock market that I think are contributing to this rising correlation of stock prices and frustrating stock pickers.
Unlike when I first got into this business in 1982, most of the trading volume in the stock market today is not the result of fundamental analysis of individual companies. Computer-generated “high frequency trading” now accounts for about 70 percent of the daily trading volume.
In addition, Exchange Traded Funds (ETFs) have become popular investment vehicles for hedge funds, other institutional investors and traders. These funds just mirror indexes. There is no consideration of the investment merits of each company within the index. Hedge funds and professional traders use ETF’s to quickly increase or decrease their exposure to the stock market in reaction to the daily macro issues.
Computer-generated and index trading undoubtedly increase the correlation of stocks to an index over short periods of time. However, the stock prices of individual companies will reflect company fundamentals in the long run.
I think that macro concerns will tend to dominate micro or individual company analysis until there is more confidence in an economic recovery. The short-term rallies and sell-offs in the stock market will continue to be based more on “risk on” or “risk off” trading strategies as reactions to macro economic or political events.
In my effort to manage risk for my clients’ portfolios, I will always incorporate a macro economic and market analysis in my investment strategies. Recessions and bear markets will probably be more frequent going forward than they were in the 1980s and ‘90s, which will require taking defensive actions to protect the portfolios at appropriate times.
However, I also believe that correlations among stocks will decline with a sustainable economic recovery. When that happens, good old-fashioned stock picking will add value to portfolios and differentiate those skills of investment management firms as it has in the past.
John W. Gudritz CFA is a principal at Front Street Investment Management LLC, a fee-only investment management firm in Traverse City. Reach him at 866-933-7668 or visit www.frontstreet.com.