Show us the evidence! This was the overwhelming response from FT readers to my previous column on why sideways markets make a case for active fund management.
I wrote the column in July. Since then we’ve had chaos in the White House, sabre rattling in North Korea and some noteworthy disappointments, including Britain’s highest profile fund manager — Neil Woodford — losing almost £300m of investors’ money on a single company.
Other than sending a few short-term ripples through stock markets and a fleeting rush to safe havens, the market has kept going. Or rather, it has shuffled sideways.
Let’s park that very short-term view for now, and wind the clock back a bit further. In 2010, Robert Hagstrom, chief investment strategist at Legg Mason Capital, but probably better known as a biographer of Warren Buffett, wrote a paper entitled “Who’s Afraid of a Sideways Market?”
Looking at the US market over the period from 1975 to 1982, a well-documented flat market, Mr Hagstrom identified stocks that had, over different periods, returned 100 per cent or more. He also looked at which factors were most and least profitable for investors over these periods.
In any one-year period he found that only a small percentage — about 3 per cent or 16 of the 500 of the stocks that make up the S&P 500 — doubled in value. However, over longer time periods the number of companies doing so increases exponentially. Over a three-year period, 18 per cent of companies doubled, while over a five-year period, 38 per cent did. That’s 190 out of 500 stocks.
There are some obvious conclusions you can draw from this piece of research. First, over the long term, the average matters less, even if that “average” is a market which does nothing more than drift sideways. Second, even in flat markets, good stock picking can deliver outperformance. Third, to reap the rewards of stock picking, managers have to adopt a longer view. They need to invest in stocks, rather than trade stocks.
And if you need any further evidence that a good stock picker can outperform in crab-like markets, you need only look to Mr Buffett, who managed to deliver average returns of 34 per cent a year during the zombie market of 1975 to 1982.
There’s an obvious problem with Mr Hagstrom’s research: it only covers a single period of stock market history. But sideways markets have been more common than you think. Take a look at charts comparing the S&P 500 in 2011 with 2015, and with the exception of a little less volatility in 2015, the years are eerily similar. In both years the market traded sideways from January to December, despite some historic volatility and market swings in between.
Of course, sideways markets aren’t confined to the US. Fidelity’s equity research team under the steer of Paras Anand, chief investment officer for equities in Europe, took Hagstrom’s research one step further by looking at four periods of becalmed markets in Asia, Japan, the US and Britain.
The team found that the number of stocks making outsized returns in these sideways markets was comparable to Hagstrom’s findings in the US in 1975-82. Their measure of this was a stock rising more than 75 per cent over a three-year period. In the US, 93 of the S&P’s 500 constituents achieved this level of share-price growth, while in Britain 178 of the FTSE All Share’s 605 members did so.
What about the investment strategies that worked during these flat episodes? Following the original Hagstrom study, three investment style factors were used: valuation, earnings quality (growth) and momentum. Again, the findings reflected those of Hagstrom with valuation and earnings quality easily trumping momentum.
We’re all poised to believe the market will do something erratic — an overvalued market will be corrected, an irrationally exuberant market will crash, the next major correction or downturn looms.
Never has there been a more grudging bull market. But this market hasn’t been pushed higher by a fear of missing out. It’s been driven by an overwhelming desire for capital security or perhaps a modest gain — an excess of prudence rather than exuberance. Scarred by the financial crisis, it is investors’ fear of losses, rather than their desire not to miss out on gains, that has fuelled the market.
Here’s the thing: what if the real danger isn’t Pyongyang launching ballistic missiles, Trump’s Twitter tirades or central banks taking the patient off the medicine too soon? What if the real danger is the chronic underachievement of a sideways market?
If so, we’d better heed Hagstrom’s advice from back in 2010: “Who should not be afraid of sideways markets? Stock pickers. Whether the approach is to select stocks that pay higher dividends or companies that are growing shareholder value at an above-average rate, I believe the game is now in the hands of those investors who can identify mispriced stocks.”
Markets will drift sideways from time to time, and it’s very likely we’re caught in another one of these crab-like episodes. For stocks to grind higher, you need a little bit of “good inflation”. But 10 years on from the financial crisis, central banks’ plans to reflate economies have still not worked.
I believe this is down to structural factors beyond the control of central banks — for example, an ageing and shrinking population limiting the size of the global workforce, which also suppresses economic activity. Rising inequality too. And let’s not forget the growing cohort of self-employed people with limited earning power — freelancers, contractors, Uber and Deliveroo drivers in the so-called gig economy, with less money to spend.
Less economic activity and less money to spend means prices are unlikely to be driven upwards. Simply put: central banks in the developed world can print money but what they cannot do is print people.
With low inflation and tepid economic growth, however, they’re unlikely to turn off the taps of monetary stimulus. Rates will stay low, markets will flatline and returns will remain elusive. Good news for borrowers, bad news for passive index trackers.
Even more reason to stick with a seasoned stock picker who can roll up their sleeves and use the resources and insight at their disposal to unlock returns in a sideways world.
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