When markets shuffle sideways, stock-pickers should come to the fore – if they can avoid buying and selling too quickly.
Since the mid-1990s, global equity markets have been nothing if not dramatic. The S&P 500 has witnessed two large market bubbles and two major crashes during the period – the latter came in 2000–02 and 2008–09. Since then, the world’s leading index has more than trebled in value.1
As a result, many investors have forgotten (if indeed they ever knew) that there is a third kind of market – the sideways market. In fact, sideways markets were common through much of the 20th century, as Robert Hagstrom2 recounted in a paper published in January 2010.3 On 1 October 1975, the Dow Jones Industrial Average sat at 784. On 6 August 1984, it again closed at 784. That’s a period of almost nine years with, ultimately, no capital growth.
At first glance, such statistics look disheartening. Moreover, there has been a great deal of speculation in recent weeks that the current bull run – the second-longest in history4 – may yet run out of puff, resulting in a sideways market in the coming months; the FTSE 100 has risen just 1.5% in 2017 thus far, having risen more than 16% across the last calendar year.5
In such circumstances, some fear may in fact be appropriate, but only for certain types of investor. Hagstrom’s research demonstrated that sideways markets are a problem for those who like to follow the herd – generally through some form of passive investing.6 But he found that they are not necessarily a problem for stock-pickers.
Pick of the bunch
So what average annual returns did Warren Buffett, the consummate stock-picker, generate in the zombie market of 1975 to 1984, during which the S&P 500 made no overall gain?
The answer is no less than 34%.7 Yet Buffett is no day trader. His success has come as a stock-picker who buys the best companies he can for the long term – thus his well-rehearsed line: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
In his research, Hagstrom discovered that the apparent flatness of the broader index tends to mask considerable price movements in the constituent stocks. “What we first thought to be a trendless sideways market was in fact a market full of variation,” he concluded in the report.8
This is especially significant for stock-pickers. When markets rally or decline sharply, correlations between individual stocks tend to rise – in other words, stocks increasingly move in sync. In sideways markets, however, correlations are often quite low, meaning that the prices of individual stocks head in different directions – yet the net result is a sideways crawl for the index itself. This kind of market provides stock-pickers with exceptional opportunities to profit from identifying undervalued stocks.
When Hagstrom dug deeper into the stocks themselves, it only strengthened his case. In any individual year during the period under scrutiny, Hagstrom found that just 3% of the stocks on the S&P 500 were able to provide a return of 100% (i.e. double in value). But push that up to three years, and the figure was 18.6%. For long-term investors able to avoid selling for five years, the figure was higher still – 38% of the stocks listed on the S&P 500 doubled in value. At that point, the average increase in the broader market matters even less – what matters far more is choosing the right stocks.9
In short, if stock-pickers do their homework on the companies they are investing in, then they need not fear sideways markets.10 Instead, they should focus on sticking to the script – investing for the long term in those companies that offer real opportunities. Too many sideways glances can prove costly in the end.
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The opinions expressed are those of Mark Beveridge of AXA Investment Managers and do not constitute investment advice. This is not a recommendation to purchase, sell or subscribe to financial instruments, an offer to sell investment funds or an offer of financial services. This does not constitute a Financial Promotion as defined by the Financial Conduct Authority. No financial decisions should be made on the basis of the information provided. The views are not necessarily shared by other investment managers of St. James's Place Wealth Management.
2 Robert Hagstrom is Senior Vice President and Director of the Legg Mason Focus Trust and author of the bestselling biography The Warren Buffett Way
4 The current bull run is the second-longest in the history of the S&P 500: https://seekingalpha.com/article/3987722-2nd-longest-bull-market-history
6 In the paper, Hagstrom compares active stock-picking with two other forms of investing: index investing (a stategy which aims to replicate the performance of the selected index) and momentum investing (buying and selling stocks in line with their performance over the previous 3–12 months, as defined by Jegadeesh and Titman: http://www.e-m-h.org/JeTi93.pdf)
7 See 2
8 See 2
9 See 2
10 Note that Hagstrom’s findings are not only applicable to the single period he analysed. New research published in 2017 by Fidelity showed similar trends at play in the US, Japan, Europe and UK during four different periods of ‘sideways markets’: https://www.fidelity.com.sg/market-analysis/fund-perspectives/who-s-afraid-of-a-sideways-market-article