In the wake of the very strong November unemployment report, the stock market has swung to the belief that the Federal Reserve will tighten at its December meeting. This is very different than its outlook after the October unemployment report. I bring this up because monthly data varies widely, which is one of the reasons each initial report is revised in subsequent months. It is always better to average three or four months of data than rely on a single month. That said, the move has resulted in a significant jump in interest rates. Stock investors are trying to get a handle on this. Remember – stocks soared in October and it was presumably on the notion that the Fed was on hold at least through the end of the year. It should come as no surprise, therefore, that a change in the outlook for interest rates would mean a change in the short term direction of stocks. It should be noted that we will get the December Unemployment report before the next Federal Reserve meeting, so more twists and turns could be in store.
Michael Mauboussin of Credit Suisse did a thorough study of active management that I found very interesting. Here is the Readers Digest version. He concluded that there were three ways for active managers to outperform: (1) market timing (strategic use of cash) (2) security selection and (3) portfolio construction (asset allocation).
I’m sure his conclusions come as no surprise. Also not surprising is that there is little evidence that market timing works over the long term. It works during certain periods of time marked by trending markets (in either direction) and tends to do quite poorly in choppy, directionless markets. Active management can add value through superior security selection during periods of wide dispersion, the study showed. They also tend to do better when small company stocks outperform larger ones. When stock dispersion is low (as it has been for most of the past two years), passive is a superior strategy. Dispersion is also the key to adding value through asset allocation, in that wide dispersion creates a better opportunity for under- or over-weighting an asset class to add alpha.
This translates into today’s market in that dispersion has been widening since mid-summer, giving active managers a theoretical opportunity to out-perform. Sadly for them, there has been a fairly strong trend toward larger stocks and growth stocks, which is the opposite direction that active managers tend to go. Investors have been trying to avoid having “land mines” in their portfolio (Sequoia and Fairholme are counter to that trend and have paid the price), so they are cutting down on tracking error. This means more money invested passively. We have seen in the last several weeks more stocks advance than decline, but the average decliner loses more than the average gainer. This is late cycle behavior (value typically does poorly in relative terms near market tops, and momentum is typically strongest). Investors love consumer-oriented secular growth stories like Starbucks and Home Depot, but they seem to hate industrial cyclicals (companies that sell to other companies, especially if they are smaller and/or their customers are overseas).
It is so hard to know what to believe when market pundits talk about “earnings”. There is all the difference in the world between reported earnings and operating earnings. CEOs want to pay taxes on reported earnings (all the bad stuff included) but want to be judged on operating earnings (all the bad stuff removed). We also get misleading information about earnings “beats” and “misses”, as if that is important information. Everybody should know by now that any competent CFO knows well before the end of a given quarter whether things are tracking well or not. If not, the company will simply guide estimates lower. That way a month later when earnings are released, they are much less likely to surprise on the downside. So when a mutual fund company strategist tells you that the economy is strong because a high percentage of firms met or exceeded earnings estimates, he or she assumes that their audience is comprised of IDIOTS. Happily, whenever this happens you now know who to NEVER LISTEN TO AGAIN FOR ANY REASON. That means you Mr. Doll.
Chuck Carnevale of FastGraphs posts articles on Advisor Perspectives from time to time. In his piece Retired Investors: Apply a Value Investing Strategy and Earn More Income and Higher Returns, he used the examples of Northrup Grumman and Medtronic to show how good companies with growing earnings and dividends can remain unloved and out of favor for four years or more before the market finally “discovers” them. Value investing is not for the impatient or faint hearted, but it does offer the opportunity for added performance. In my experience, the alpha comes from the fact that value has a negative skew (most of the time it modestly underperforms but when it is in favor it tends to do much better). Most investors are more psychologically suited to momentum, because that strategy has a positive skew.