Monday markets: Index investing yielding to stock picking?

Since the start of the Great Recession, index investing via ETFs has killed off stock pickers. But under Trump, the pendulum is swinging the other way.

Alice and Dodo.
Caucus Race from Lewis Carroll's "Alice in Wonderland," illustration by John Tenniel. (Public domain.)

WASHINGTON, February 13, 2017 – Is the index investing Caucus Race over at last? In the stock market over the past eight or nine years, it’s been hard to identify macro trends until such trends are well underway, so it’s often been safer and more profitable to invest in index ETFs and not look forward to doing much better.

Older guys like the Maven have an advantage in this area, however. They’ve witnessed cycles repeat themselves so many times that they’re able to identify trends before they can even support the arguments in favor of those trends, and investing purely through ownership of index ETFs may be a trend that’s drawing to a close.

Last summer, as everyone in the known universe trashed the presidential candidacy of Donald Trump and laughed at the Republicans’ chances of retaining their Senate majority, stocks took a pause and then started behaving strangely. Stock sectors that represented housing, construction and basic resources started to catch interest again, while financials stopped their relentless slide and stabilized with a slightly upward bias.

The market was telling us that the eight miserable years of Barack Obama’s and the Democrats’ grinding, anti-American socialist era was drawing to a close. Things were about to change in a big way, and classic financial and cyclical stocks of companies that would drive an American business renaissance would be the first to move.

The market was telling us that regime change was about to occur.

Very few were able to see or hear this message, since all those sage pollsters, political prognosticators and all-wise TV pundits and professors said regime change would never happen, given the ignorant buffoon the Republicans—the Stupid Party—had allowed to become their standard bearer. But Mr. Market was quietly saying otherwise while laying a trap for the smug and unwary.

After an initial downdraft at the NYSE opening bell on Wednesday, November 9, 2016, stocks took off like a rocket ship when Donald Trump proved to be the surprise victor in the Presidential sweepstakes, with the powerful and generally unexpected Trump-Santa Claus Rally kicking financial, industrial and materials stocks up, up and away toward new post-recession highs.

Stock averages like the Dow, the S&P 500 and the NASDAQ moved right along with these sectors, as the trade here ignited other previously moribund sectors as well. But what often escaped notice was this: instead of all stocks moving in precise lockstep, some sectors, as well as many individual stocks, started outpacing those averages, sometimes by a considerable margin.

All the while, we’ve been reading about the death of old-fashioned stock-pickers. You know, those legendary old guys who’d pick sometimes completely unknown or un-followed companies that would beat the averages by a mile. Stock picking had been killed by the Great Recession and the economically clueless Obama administration, which only knew how to give away borrowed money, not how to make new money in an improving economy.

Fueled by cheap printing press money via the Federal Reserve, institutions went on an indiscriminate buying binge, instinctively understanding that buying almost everything in the stock market would produce the same results, since stocks became about the only place where you could stash money and still have the chance to make something more than the 0.01 percent you made by allowing your funds to languish in nearly zero-interest rate CDs.

In this environment, picking stocks was a waste of time. If everything was moving in lockstep, why not just dump all those excess funds into Index ETFs that followed the major averages or given sectors like consumer goods that the geniuses in Washington seemed to favor? This was easy and cheap, and these indexes seemed to beat the selections of those expensive stock pickers each and every time.

But now, with a whiff of competition and animal spirits returning to American business as well as Wall Street, we may be going back to the future with regard to how corporations and individuals invest their money.

The Maven has felt rather alone in divining Mr. Market’s increasingly clear intentions going forward. But he discovered he actually has some company, courtesy of a CNBC article posted to their online site this morning. To wit:

“There’s been a big shift in the way stocks are moving, but it’s one many investors may have missed.

“Since Donald Trump’s election, the correlation of the average S&P 500 sector to the S&P 500 as a whole has fallen dramatically. Or to put it more simply, different groups of stocks are following their own separate tunes to an extent that they haven’t for years.

“‘For the entire time from the financial crisis through the election last year, assets in the U.S. market all traded largely the same way,’ Nicholas Colas, chief market strategist at Convergex, said Friday on CNBC’s ‘Trading Nation.’ ‘Now, sectors are moving a lot more based on their own fundamentals, and it’s really the first time since 2009 since we’ve seen it.’

“‘It’s really a big change,’ Colas added.

“One potential explanation for the shift — which Colas says he ‘chalk[s] up entirely to Donald Trump’s victory’ — is that the president’s potential economic policies could create winners and losers. [Italics here and below by the Maven.] For instance, a greater tax on imported goods would be good news for U.S. manufacturers that compete with foreign companies, but trouble for retailers that import much of their inventory from abroad….

“‘Getting sector and stock bets right just got a whole lot more serious,’ as Colas put it in a Friday note. If one sector performs very differently from another, investing in the right one becomes that much more important. This means active managers can stand to make much more off their bets, though it also means they can stand to lose more (relative to the overall market).”

The Maven is feeling vindicated for sensing this move a bit early, proving that listening to Mr. Market is still the best way to get investments right, even if Mr. Market seems to be going against perceived public opinion.

There’s really no need to get into the psychology of all this. It’s sufficient for small investors like the Maven and his small but select band of loyal readers to just look, listen and follow.

This potential sea change in investing approach doesn’t mean that you can’t make money in the wonderful world of stock index ETF investing. Indeed, the Maven almost always has allocated funds to index and sector ETFs that show the most promise in the intermediate term.

After all, since neither you nor the Maven can identify as malefactors of great wealth, we can’t buy all the stocks we like in an individual sector and then bask in the inevitable profits earned by our surpassing genius. But we can still acquire a basket of representative stocks in such areas via appropriate ETFs, while putting a bit more money in individual stock bets that show greater promise (and dividends).

Among other things, this means that writing this column will start to be more fun in the coming months as we can start paying more attention to stocks that might actually give us outsized return as opposed to running the kind of investment Caucus Race we’ve been running for over 8 dreary years. Index and sector ETFs will continue to have a place in smaller portfolios. But stock picking, fundamental analysis and technical analysis are finally beginning to be useful tools once again, and that’s a very good thing indeed.

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