Stock pickers are getting schooled on just how hard it is to outsmart this pandemic-driven market.
After the S&P 500’s biggest plunge since the March madness on Thursday, expectations are rising that shares will move in lockstep again, a headwind for stock pickers looking to divine winners and losers. Add the fact that fewer companies are leading market gains this week, and it’s looking like a tough summer for those who pick securities for a living.
Active managers are coming off a dispiriting stretch. More than 60% of domestic equity funds underperformed the S&P Composite 1500 in the first four months of 2020, according to data this week from S&P Dow Jones Indices. That means investors largely failed to prove their mettle during the most extreme price swings in modern history.
After finding reason for cheer in calmer trading conditions just weeks ago, the question is whether active managers can find overlooked stars and discover securities that sway to their own beat.
“The intra-sectoral correlation is very high again,” said Roger Jones, head of equities at London and Capital Asset Management Ltd. “This normally happens when volatility picks up, when markets are driven more by the top-down than the bottom-up.”
The benchmark U.S. stock gauge pared the early advance in Friday trading, while Wall Street frets a second virus wave and a rally that’s defied the economic downturn.
Anyone with stock-picking smarts has been grappling with virus headlines in a macro-driven market for months now, but lately there’s been reason for optimism. As early as Monday, correlations had dropped to levels last seen before the sell-off, and beaten-up shares were in the midst of a historic comeback. Money was rushing in to chase the rebound as major economies gradually re-opened and U.S. jobs data unexpectedly improved.
Yet on Thursday, pros who had been sounding the alarm over elevated valuations looked prescient, as shares slumped after the Federal Reserve warned of a long path to recovery and infection rates ticked up in parts of the U.S.
The implied correlation of S&P companies spiked to the highest in more than two months, while an equal-weighted version of the index looks set for its second-worst week versus the regular capitalization-weighted version in data going back three decades.
Meanwhile the outlook for small caps looks grim after economic shutdowns across the world. The Russell 2000 Index of small caps is set for its worst week versus the S&P 500 since April.
That’s a problem for active managers who are known to overweight the cohort. The correlation between the outperformance of small caps and the excess returns of active managers has only risen further since the global financial crisis, according to an analysis by Sanford C. Bernstein.
“Given the unprecedentedly abrupt nature of the drop in revenues, it is likely that more small caps will not survive than would be the case in a ‘normal’ recession,” the Bernstein analysts wrote. “The skew to mega cap returns means that managers need to be ever more concentrated in order to outperform.”
The dominance of mega caps is another fly in the ointment. As their stellar returns make the market more concentrated -- just pull up a chart of Amazon.com Inc. or Apple Inc. for evidence -- it’s become hard for stock pickers to have sufficiently large wagers to beat their benchmarks, strategists Alla Harmsworth and Harjaspreet Mand suggested in a note last Friday.
Another challenge for active managers lurks in the underbelly of the stock market beloved by quants.
Factors -- the characteristics of shares tracked by systematic funds -- are driving the largest portion of the S&P 500’s returns in about a decade, Evercore ISI’s calculations show. That suggests that a fund manager picking stocks by slicing and dicing the corporate earnings trends might find their skills overwhelmed by broader forces like a global rush for havens.
Of course, individual managers correctly positioned for market turns have notched stellar returns from the turmoil. And one bull case holds that as easing credit stresses alleviate immediate anxiety over bankruptcies, investors can re-focus on the basics of stock-picking.
Over at London and Capital, Jones’s team tries to take advantage of sell-offs by scooping up stocks with longer-term appeal. But when it comes to a once-in-a-generation pandemic, some humility is in order.
“What confidence do I have in my views? It’s probably not great in terms of all the moving parts in the economy,” he said.
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