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When a Rising Tide Becomes a Whirlpool

By Jim Pearce on September 22, 2017

 

The solid rise in the S&P 500 over the first eight months of this year has given rise to the fallacy that the entire stock market is doing well in 2017. Um, not really.

To be sure, on an equal-weight basis, the average stock in the index rose 8.6% from the beginning of January through the end of August. But this is a case where averages can be misleading since there is broad divergence in performance from one company to the next, even within the same sector.

Pick the right group of stocks and you’re having a great year, but pick the wrong ones and you may be getting a margin call from your broker. A year ago, one standard deviation in performance for the S&P 500 Index was 18.5%, approximately twice its mean return of 9.1% at that time. This year, one standard deviation equates to 22.4%, or more than two and a half times its average gain of 8.6%.

The net result is that over the past 12 months the average return for the index has decreased by 5% while the standard deviation from its arithmetic mean has increased by 30%.  [graphic]

That’s due to the “winner takes all” mentality that surrounds a number of momentum stocks, such as online retailer Amazon.com (NSDQ: AMZN) which gained 25% over the first eight months of this year while many other stocks in the retail sector plummeted at the same time. Likewise, trendy electric car manufacturer Tesla (NSDQ: TSLA) rose nearly 60% while conventional auto makers Ford (NYSE: F) and General Motors (NYSE: GM) lost ground.

The same principle even holds true for the tech sector, which is widely regarded as the only industry that is mostly impervious to the geopolitical events that rile the markets. Apple (NSDQ: AAPL) increased its already world-beating market capitalization by 38%, while Cisco (NSDQ: CSCO) only broke even and Intel (NSDQ: INTC) shed 5% of its value.

What that means is that more investors are deploying a “bottom up” approach to picking stocks based on their individual merits, rather than a “top down” process that first identifies sectors likely to outperform the overall economy before zeroing in on specific companies to own.

The benefit of choosing your own portfolio of stocks is apparent in the performance of our PF Growth Portfolio. The average gain of the 17 stocks that have been in the portfolio during the past 12 months (through 8/31/2017) is 18.6% on an equal-weight basis, compared to 15.6% for the index on a capitalization-weighted basis.

Our top three performing stocks over that period — tech giant Apple at +57.3%, bricks & mortar retailer Best Buy (NYSE: BBY) at +43.8%, and financial services provider Ameriprise Financial (NYSE: AMP) at +40.7% — prove that you can find exceptional opportunities across all sectors. But you have to be careful. There are plenty of duds out there, and as the dispersion between winners and losers widens, the penalty for owning the wrong companies will become increasingly severe.

Case in point; oil producer Apache Corp. (NYSE: APA) declined by 32% over the past 12 months, while oil refiner Marathon Petroleum (NYSE: MPC) increased by 27%. As an indexer, if you owned the Vanguard Energy ETF (NYSE: VDE) then these two holdings on average contributed -6% towards that fund’s total return of -7%. But as a self-directed investor, if you owned Marathon and fellow PF Growth Portfolio energy holding Chevron (NYSE: CVX), you would have realized an average return of +19.3%.

That same dynamic, replicated over hundreds of companies, illustrates the growing risk to index investors in the waning days of an overextended bull market. At some point, the spread between top performing stocks and those at the bottom will become so wide that just a small shift in equilibrium could send the index tumbling.

That’s why we employ a disciplined, rules-based approach to managing the PF Growth and Income portfolios. We believe the stocks that pass our IDEAL and SHIELD tests are less likely to take a dive than their overpriced peers. In contrast, you can’t find many commentators discussing the growing divide between the haves and have nots in the stock market. Instead, they continue to extoll the virtues of indexing as the best way to ensure achieving average returns.

That’s okay, provided the index average accurately reflects how most stocks are performing. But that’s not the case anymore, and investors that ignore it could be in for a nasty surprise when the next correction rolls around.

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