November 1, 2004
A New Era of Market Efficiency?
With the S&P 500 up less than three percent year-to-date despite good corporate earnings growth and an ostensibly recovering economy, 2004 has been a predictably frustrating year for buy-and-hold investors. Less predictably, the amount of dispersion in the market – as measured by the difference in performance between various industry groups and the relative performance of various investment styles – has been among the narrowest in many years, making 2004 equally frustrating for active managers. There are, of course, narrow styles that have performed well, particularly in the energy sector, but for diversified approaches, the lack of available dispersion has been unusual.
In our own case, to put it bluntly, the returns I've achieved in managing the Strategic Growth Fund have been flat and unsatisfying this year. On the metrics I actually use to evaluate performance (peak-to-peak returns, drawdowns, and risk-adjusted returns), the Fund has continued to behave as intended, but that doesn't provide much solace about our modest year-to-date returns. In any event, I think it's always useful to discuss the factors behind our performance – satisfying or not – in order to provide short-term context to our long-term investors, but I am never willing to depart from our investment discipline in an attempt to chase short-term returns for short-term investors.
The recent lack of traction – even from strong managers – hasn't escaped the attention of journalists. On both Monday and Friday, the front page of the Wall Street Journal 's Money & Investing section featured articles on the subject. Monday's Journal noted “funds frequently employ strategies that depend on one asset or group of assets doing well relative to another, like taking a long position in one stock and taking a short position in another one in the same industry… A recent study found that opportunities to take advantage of pricing inefficiencies have eroded in the equity and interest rate markets.”
Friday's Journal noted “Bill Miller isn't the only mutual fund star having a less-than-stellar 2004. While this may be the year that ends Mr. Miller's 13-year winning streak versus the Standard & Poor's 500 stock index, his is just one of a number of large, well-known funds that rank in the bottom 20% of their Morningstar Inc. categories this year despite ranking in the top 20% - or even the top 5% - over the past decade. ‘These managers are willing to stick their necks out and build a very different portfolio' than their average peer or a relevant index, says Russel Kinnel, director of fund research at Morningstar. And while that approach contributes to their long-term success, he says ‘you have to appreciate that you are going to have some off years.' Mr. Miller, who wasn't available for comment, has said that he invests for the long term and doesn't make short-term adjustments in an attempt to prolong his streak against the S&P 500. ‘We remind clients that we think about the portfolio in terms of the returns it may generate over a three-to-five-year time horizon.'” Amen to that.
It's tempting to look for an easy explanation for this year's lack of dispersion. For investors who believe that whatever is currently happening in the markets is the way that things will always be (thinking that brought us the “death of equities” in 1982, the “new era” economy in the late 1990's, and Nasdaq 5000), the lack of traction from various investment styles means that hedge funds have finally whittled away all the inefficiency from the market and active management is now passé. Moreover, if you buy Jeremy Siegel's argument, valuations can stay at current elevated levels forever, because investors now realize that historical risk premiums were too high. The implication is that a 7% long-term return on stocks is completely fair and indefinitely sustainable, and no investment approach will beat passive indexing anyway. Now there's a depressing thought.
Fortunately, for those of us who believe that impermanence is the nature of the markets, there is far more hope and optimism. Since I spend much of my time staring at the data, here are my impressions.
First, it is the nature of major market movements to generate dispersion, and the nature of corrective movements to narrow it. For example, the market's advance from 1995 through 2000 had two phases, both which widened the dispersion in the market. The first phase emphasized large-cap stocks, making large-cap value investors like Warren Buffett seem infallible by 1998, when stocks like Gillette, Coca Cola and others reached their peak valuations. In the second phase from November 1998 through the 2000 peak, large cap stocks continued to perform well, but technology stocks took a fantastic lead. Even so, despite the market's extreme overvaluation (breathtaking in the case of tech), there was a very large group of stocks, generally at small and middle capitalizations, that represented good value and had sufficiently favorable market action to perform well even if one avoided the large-cap tech stars like Cisco, Sun, Oracle and EMC.
As the market plunged from 2000 through early 2003, some of those imbalances corrected, with tech leading the way down (the lowest-quality stocks having poor balance sheets being particularly mauled). Meanwhile, smaller value stocks actually moved sideways overall, and in some cases even gained a modest amount of ground.
Finally, the corrective advance from early 2003 through about April 2004 closed some of the remaining dispersion, as smaller stocks made up for their terribly lagging performance during the late 1990's, driving the Russell 2000 Index to much stronger 2003 gains than the recovering large-cap indices.
From this perspective, the period from 1995 through 2004 really involved several “sine-waves” of dispersion: tech gained momentum, then soared, collapsed, and then corrected higher, large caps advanced, plunged, then also corrected higher, while small caps languished then soared. In part, the challenge of active management is develop an overall investment discipline, a set of analytical tools, and a plan of daily actions that will tend to capture portions of that sort of dispersion. In our case, I believe that the consistent focus on favorable valuation and favorable market action naturally serves that objective.
Looking at the market's performance in 2004, our investment approach doesn't allow us to get much benefit from markets that feature strength in very low quality stocks, so we didn't pick up much of the final strength in these issues during the first quarter. At the industry level, aside from energy stocks, the performance spread between various industry groups has been the narrowest in a decade. Meanwhile, value has not been a reliable theme this year. Though many value stocks have achieved excellent returns, others having quite good apparent valuations such as Merck also suffered unanticipated surprises that suddenly made those low valuations more-or-less warranted.
Even without dispersion among various stocks, investment styles, and industry groups, it would still be possible to garner good investment returns from taking broad market risk (e.g. a passive exposure to, say, the S&P 500), if that was being rewarded. Unfortunately here as well, the market's high overall valuations and flat market action have also made it difficult for a buy-and-hold approach this year.
A new era of efficiency?
The real question, looking ahead, is whether the market has finally been emptied of its inefficiencies for now, or even permanently. In my view, the answer is no. I think it's reasonably clear that if the market were to launch into a massive bear collapse here, the amount of dispersion would probably be smaller than we saw during 2001 and 2002, when tech stocks were coming off of stratospheric valuations and huge market capitalizations. Even so, my impression is that financial stocks have enjoyed an unusually long cycle of investor favor, and that their valuations really aren't reasonable if one factors in a flatter yield curve and much slower growth in mortgage and refinancing activity. I continue to view a light allocation to financials as appropriate, with offsetting higher weights in industries with stable revenue growth, where profit margins are not very sensitive to economic fluctuations.
Just as importantly, I continue to see quite a wide range of valuations across individual stocks even within various sectors such as consumer, healthcare, industrials and technology, and those relative valuations have historically been a very good source of investment returns, though the timing of those returns is not highly predictable since they are more stock-specific.
Overall then, it's clear that the menu of options for return generation has been unusually short this year. That's not satisfying, of course, but it happens from time to time. The more important question is whether that represents a “new era of efficiency” in which nothing works anymore, or whether instead it is a temporary period – albeit of unpredictable duration – and just a prelude to new inefficiencies, market fluctuations and dispersion.
My opinion is simple. The only thing permanent in the stock market is that the condition of the stock market is never permanent. Despite the lack of dispersion in recent investment returns, I continue to observe good dispersion in investment valuations. Of course, valuations are generally the predecessors to subsequent returns. In my daily management of the Strategic Growth Fund, I continue to focus on regularly building what I view as favorable valuation and market action into the portfolio as new opportunities emerge.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and still modestly favorable market action. For now, that holds the Strategic Growth Fund to a less-than-fully hedged position. Presently, the Fund has a hedge that retains about 20% of the exposure of our stocks to overall market fluctuations, which (due to curvature inherent in call options held by the Fund) would grow toward about 50% on a sustained market advance. Of course, the day-to-day returns of the Fund are also influenced by differences in performance between the stocks held by the Fund and the broad market. Suffice it to say that I view the portfolio as having very good valuations relative to the market, a reasonably strong hedge against any potential market weakness, but sufficient exposure to market fluctuations to expect some participation in any further market advance that may emerge. Again, despite valuations that price the market to deliver unsatisfactory long-term returns, there is enough speculative merit evident in market action to prevent us from taking a fully-hedged stance for now.
In bonds, the Market Climate remains characterized by modestly unfavorable valuations and modestly favorable market action. There is increasing evidence of economic softness, however, so I would anticipate using any substantial weakness in the bond market to increase the duration of the Strategic Total Return Fund modestly. At present, that duration remains just under 2 years. Given that economic weakness tends to be a substantial positive for gold stocks, and that the Market Climate for precious metals remains generally favorable, I also anticipate using any substantial weakness in precious metals as an opportunity to increase our exposure modestly here as well. At current prices, I continue to be very comfortable with our present 14% exposure to precious metals shares in the Total Return Fund.
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