Insights & Advice

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Is it a Stock Market or a Market of Stocks?

“There is no difference,” you might say and you would be wrong.

The answer, unfortunately, is that we are dealing with a stock market. Today and possibly for years into the future, this important distinction will require an entirely new mindset for most investors who want to preserve wealth and, at the same time, grow your portfolio.

Back in the day (when I still had some hair), stocks and the market had a lower correlation, meaning they did not move in tandem. As a result, I considered stocks first and markets second. There was always a dog-eared copy of my financial bible, Graham and Dodd’s “Security Analysis”, in my briefcase on my visits to company managements. While walking through their factories, mines or warehouses, I would ask a ton of financial questions, scribbling notes as I went. Back in the office, I would put together a spreadsheet, crunch a week’s worth of numbers and come up with my financial analysis of a particular company resulting in a buy, sell or hold decision.

Let’s say I came to the conclusion that the company’s stock was a buy. If I did my homework correctly, and purchased the stock, I had a reasonable expectation that the stock price would go up, regardless of what happened in the overall stock market. I could apply a similar analysis in looking at sectors, like financials, pharmaceuticals, etc, and even in selecting which countries looked attractive (or not) like China or Greece.

But this practice began to shift over the last decade. I noticed that stock prices, sectors, markets and even countries began to exhibit a higher degree of correlation. Year after year that trend appeared to accelerate as markets began to move in the same direction regardless of fundamental changes in outlook. Today, correlations among stocks are at record levels, which mean that almost all stocks move in the same direction as the market, given enough time.

As a result, the pedantic thinking spewed by financial professionals that investors should be well-diversified among asset classes carries a lot less weight. Stock pickers, too, are finding it extremely difficult to generate returns that are better than the market no matter how good the company’s prospects might be.
What explains this sea change toward higher correlation?

Normally, correlations rise when stock prices decline. In other words, investors do not discriminate among good and bad stocks in a bear market. Just recall the free fall in 2008-2009. Most readers are aware that I believe we are in a secular (long-term) bear market, which will be with us until at least 2016-2017. In bear markets there is a continued atmosphere of uncertainty, punctuated by periods of sharply declining prices (2002-2003 and again in 2008-2009, for example). So correlations will be higher in this atmosphere.

There was a time when I could trade on the Ivory Coast’s stock market for just a few hours a week (when electric power was available) and what happened on Wall Street or London meant little to market participants there. But globalization and the internet have changed all that. We are now in a global marketplace where what happens to Chinese exports today has a direct and immediate impact on an industrial company in Peoria tomorrow. And correlation doesn’t stop with just stock markets. Today, bonds (inversely), commodities and currencies show a high correlation with stock markets as the financial debt crisis impacted all asset classes.

Exchange traded funds ( ETFs) are also contributing to this high correlation. ETFs are a form of index fund that invests in a group of stocks that make up an index, such as the S&P 500 or the Dow Jones Industrial Average. ETFs now account for 6.5% of the total market value of U.S. stocks. So when you sell (or buy) an ETF, you are selling/buying a basket of stocks at the same time.

ETFs, combined with the proliferation of computerized program trading by huge institutions with trillions in assets, now account for a significant share of the New York Stock Exchange volume. Program trading, like ETFs, buys or sells baskets of stocks. These trades tend to magnify market swings up and down engulfing all stocks, all sectors and now all countries as well.

Now for the bad news: all of the above reasons for this higher correlation of markets will be with us for some time into the future. The growth in ETF and program trading is accelerating. As I’ve said, the bear market will be with us for another 6-7 years. The debt crisis is expected to linger for at least that long (if not longer) as will the deleveraging of debt in personal, corporate and government balance sheets.

However, all is not lost. If the game changes, simply change how you play it. In my next column, I will discuss the tools you will need to navigate this ‘new normal’ in the securities markets, or at least give you the criteria necessary to hire an investment manager that can succeed in this environment.

Posted in A Few Dollars More, Portfolio Advice