Return compression, the typically unusual tendency for most asset classes and/or sectors to perform very similarly, is the enemy to investors trying to outpace the returns of a benchmark index.

First thing’s first – I don’t have a benchmark against which I judge the performance of client’s account.  We’re all humans and we tend to like comparisons. 

But in addition to being a human, I’m also a professional money manager so I tend to like comparisons in terms of alpha.

“Alpha” is (and I’ll keep this short and simple, I promise), in essence, a technical indicator used to measure the value that a portfolio manager adds (or subtracts) for a portfolio’s return.   It’s a measure of performance based on a risk-adjusted basis.

And that’s one of the reasons I don’t hold myself to a benchmark – sometimes I inject conservatism (or safety) into a portfolio and it would not make sense to judge a portfolio versus an all-stock benchmark.  And sometimes I’m very aggressive and it would be odd to make a comparison against a bond index.

But alpha is what we professional advisors (at least the more geeky of us) use to measure our value.  It tells us whether or not, within a certain parameter of risk we have accepted for the current moment, we have chosen good investments. 

(f course we do have to take into consideration how much diversification vs. risk we want to assume for a client, but that’s another topic.  Back to the subject of alpha, we advisors live and breathe with price divergences (i.e. one sector or asset class does better than another sector or asset class).    For example, say we choose to have 40% of a portfolio invested in domestic equities.  Accepting the premise that we have selected the appropriate allocation given the current risk/reward ratio for domestic equities, we advisors then attempt to add value (alpha) to a client’s portfolio by selecting the assets classes (ex. Small-cap growth, mid-cap value) or sectors (ex. Health care, consumer non-discretionary) that will do the best.  But if everything performs similarly then not a lot of ,if any, value (alpha) can be added to the U.S. stock portion of a portfolio.

And when there has not been price divergences, when asset classes and sectors have mostly acted the same way, that is called compression.  And return compression is the enemy.

There has been a lot of return compression over the last 12-months. Over the last year the percentage of S&P 500 stocks that outperform that index has dropped from 60% (about the highest since 2002) to 41.2% (the lowest since about 2000).  So while that was clearly bad news for investors trying to beat the overall market last year, our job now is to determine how to use this current knowledge.  In other words, what does this type of return compression mean for the outlook of the stock market?  Unfortunately the signals are mixed. 

Historically (and remember, we are only looking at one indicator out of dozens and dozens) when these readings dip below 43% the market tends to follow with good strength.  But there are important exceptions.  The most recent was the crash of 2000 (when this compression ratio last dipped below 43%) as well as the just before the crash of 1987.

Combining those notable coincidences along with current overbought conditions, high levels of investor optimism (a contrary indicator), a 10-year note at 4.95% with positive momentum, and a growing list of other troubling concerns I cannot argue for this to be a period in time to take an aggressive approach to investing in the stock market.  At some point all of the investor complacency is going to turn into new worries and volatility is going to hit the market in the form of downside volatility. 

Don’t get me wrong – I don’t think that a recession is coming and I don’t believe we will see a 20%-type crash in 2007 (we’ll talk about both next year before the November 4th General Election).  But I am concerned.

On a slightly different note, I know that the investor masses are giddy with the recent stock market highs, but I continue to read the evidence as suggesting that secular risks are still high.  Stock market valuations on a relative basis (earnings yields of stocks versus interest rates and inflation) are still fine (well, if you ignore pre-1980 data).  But absolute valuations (stock prices compared to book values, dividends, sales, or sales) are high.  Prices compared to earnings are not all that bad.  But when you look at prices compared to GDP or the money supply you get a picture of a stock market that is more at its long-term top than it’s long-term bottom.

I pride myself on getting cyclical calls correct, but I’m sure I will miss one at some point – especially short-duration and short-magnitude ones.  And I’m not talking about the typical historical tendency of the market to correct five-percent from an intermediate high three-and-a-half times per year (that’s just what the market does and we embrace that).  What I am talking about is what disgusted me in the past, when so many so-called professional advisers let portfolios ride through 2000-2002.  The market goes up and the market goes down – and we’ll ride through a lot of that because it is usual and common to the stock market.  We can accept that.  But we cannot accept long-term slides.

Modified June 5, 2008