Stockpickers await their day with Godot; Will 2014 see the end of ‘risk-on, risk-off’ sentiment?

December 29, 2013 12:55 pm

Stockpickers await their day with Godot

By John Authers

Will 2014 see the end of ‘risk-on, risk-off’ sentiment? Will 2014 see the return of a stockpickers’ market? Investment managers have been waiting for it almost as long as Vladimir and Estragon waited for Godot. Year after year, at least since the credit crisis broke out in 2007, fund manager presentations have predicted an imminent end to the top-down waves of “risk-on” and “risk-off” sentiment that have driven all stocks together. This will give stockpickers the chance to shine. But it never happens.Some find the concept of a stockpickers’ market a little ridiculous. If there is such a thing, it implies that there are times when stockpickers are not needed.

But there is more to it than that. If correlations are extreme, as they were during the crisis, then there is little point in trying to identify the best-performing stocks. Correlations between stocks fell noticeably during 2013, as this column pointed out earlier this month. Could it be time for stockpickers at last to shine?

New research by S&P Indices suggests not. Correlation is not the only concept that matters. Instead, Craig Lazzara of S&P suggests that stockpickers’ chance to shine hinges on three separate concepts:

● correlation

● dispersion – the total variance in returns between stocks, and

● volatility – the extent to which stocks move around.

What matters most for stockpickers’ opportunity to outperform is dispersion. The bigger the gap between the best and worst stocks, the better those who make the right calls will look.

For example, during the crash of 2007-08, correlation was high, as all stocks fell at once, but returns were highly dispersed – banks did far worse than the rest as they led the market down. So those who avoided bank stocks, or sold them short, showed superior performance even in an environment of high correlation.

However, for active managers hoping for an imminent boon, there is bad news. Mr Lazzara’s research shows that dispersion often goes hand in hand with volatility. And volatility, as measured by the Vix index, has almost returned to the historic lows it logged during the “great moderation” that preceded the crisis.

So correlation has fallen, but this does not help much. All stocks are moving in a close range of each other. Even if they do not tend to move in the same direction as each other at any one time, meaning that they are less correlated, they do not offer an opportunity for strong outperformance as their returns are not widely dispersed.

But there are grounds for hope. 2013 was that rare year when the S&P 500 rose almost uninterruptedly, never sustaining a correction of as much as 5 per cent. Volatility that low is hard to repeat.

The combination of high dispersion with low volatility is odd, and has in the past shown itself when a bubble is forming, as in 1999 and again before the credit crisis. Generally, such complacency breeds much greater volatility down the pike. And in general, as bull markets near their end, they become more volatile. In the late 1990s, as the US equity market melted, it saw several violent corrections.

This meant high volatility, but also high dispersion. Thus those who made the right calls could look very clever indeed – and gathered assets to match. Several management groups that specialised in growth stocks rushed to prominence, while some great value managers who had sat out the bubble saw clients pull money out and in some famous cases lost their jobs.

The fading stage of a bull market can be a great time to look clever, or to look dumb. So while 2013 did not produce a stockpickers’ market on cue, active managers have good reason to hope for one in the next year, as bond yields rise, bringing uncertainty in their wake, and a five-year advance shows its age.

But again, sadly, Mr Lazzara’s research should douse their enthusiasm. First, a bubble is a good time to gather assets for a while, but in the long run it damages public faith in the equity market. History has been far kinder to the value managers who sat out the bubble – even though they cursed themselves for doing so at the time. Bubbles also confront managers with painful choices between short- and long-term targets.

There is another problem. His research shows that high dispersion allows the best stockpickers to outperform the worst by more – but it does not make stockpickers as a whole any more likely to beat the index. Even in 2008, most active managers failed to do so. This was no surprise, because active managers are handicapped by the need to pay for research and for stockpickers, and hence charge a fee for their management.

If volatility rises from here, likely as the Federal Reserve removes monetary stimulus, then stockpickers should have the chance to show what they are made of. But if they want to recoup the ground they have lost to passive index-trackers, they will have to pay themselves less.