There has been one particularly interesting stock market scenario to consider over the past year or so. The global economy could continue to surprise on the upside but the impact on the medium-term path of equity prices would be weaker. In short, there is a prospect of a period of consolidating or sideways markets. Indeed, the world may have already entered such a climate.
Why such a disappointingly neutral outlook?
The best way to address this is to consider the proposition from two angles: why could it not be much better (than sideways) and why could it not be much worse?
Despite a broadly optimistic view of the global economy and the prospect for corporate earnings growth – although the two are far less correlated than is often conveyed – there are reasons why equity prices might not push on ever higher.
First, the absence of earnings growth in the years since the financial crisis has meant that a significant part of the return from equity markets has come through multiple expansion, which means that, at the aggregate level, markets offer less value today than they did a few years ago.
Second, ongoing pressure on the returns of well-established companies and industries in the listed market continues as a result of price competition and share erosion from technology enabled business models. It feels that this process is only just getting under way, which does not suggest a ‘rising tide lifting all boats’-type environment associated with a broad bull market.
Finally, a recovery in real wage growth would be a feature of a more robust demand environment but this has been largely absent, despite most developed economies demonstrating strong employment trends. An increased return to labour is not a uniform positive for corporate earnings growth, especially at a point where many industries are already reporting margins at more or less fully recovered levels.
And why, conversely, should markets remain well supported? First, while the bulk of market returns at an aggregate level have arisen through the rerating referenced above, the valuations for equities may be full but are not obviously expensive. Certainly in any economic scenario other than a deflationary bust they are valued attractively relative to other asset classes.
Second, while the government sector remains highly indebted across most of the global economy, the corporate sector has strengthened balance sheets over recent years and this, in combination with low financing costs, has supported a relatively healthy corporate activity environment over the past few years. It feels, therefore, that if market levels drift down substantially on concerns around the near-term demand environment, industrial buyers will step in where institutional investors are more fearful.
Robert Hagstrom, chief investment strategist at Legg Mason Capital but arguably best known as a Warren Buffett analytical biographer, wrote a paper on sideways markets in 2010 from which I borrowed the title for this piece. What I wanted to ascertain is how widely applicable were some of his conclusions about the characteristics of the sideways market that the US experienced during 1975-1982.
For me, the central point which emerged from Hagstrom’s paper on the market was the number of individual stocks that posted genuinely outsized returns. He looked at stocks over different time periods that returned 100% or more and what were the characteristics or factors that were most and least profitable for investors during the period.
The research offered some interesting conclusions – first that the opportunity for exceptional gains in individual stocks was not diminished by the lack of broad market direction. In any given single year, only a small percentage (3% or 16/500) stocks posted returns of 100% or more.
However, as the time periods extend (looking at the number of stocks that posted returns of 100% or more over three and five years) to more accurately reflect the holding periods of institutional investors, a surprisingly high percentage of shares posted outsize returns:18.6% for three years and 38.0% (190 out of 500 stocks) over five years. In other words, the average simply mattered less.
Secondly, the research showed that valuation (as distinct from value) and the quality of a company’s earnings were the most ‘profitable’ strategies and momentum/short-term market reaction was the least.
The challenge, of course, is that the paper looked at a single period in stock market history so what we have done is replicate the research across other markets which have exhibited the same sideways tracking characteristics.
First, we used an algorithm to identify markets (over three years or more) that have experienced unusually low absolute-price returns (Figure 1). We identified the S&P 500, FTSE All-Share, MSCI All Country Asia ex Japan, and Tokyo Stock Price index (TOPIX) as good examples.
Interestingly, the number of stocks making outsized returns in these sideways markets is comparable to the US in 1975-82. As inflation was significantly lower in the more recent markets we explored (it reached double digits during the US sideways market), an outsized return threshold of 75% was chosen to give a fair comparison for three-year rolling periods (Figure 2).
This showed that, once again, tepid broad market performance does not prevent many individual stocks from posting strong returns. Over one year, between 2.8% (FTSE All-Share) and 5.1% (TOPIX) of stocks achieved outsize returns, but this rose to between 10.8% (MSCI Asia ex Japan) and 29.4% for the FTSE All Share over the three year period.
And what about the strategies that worked? Following the original Legg Mason Capital study we performed a quantitative factor analysis of stock returns for these indices in the sideways market periods, constructing long/short strategies driven by three investment style factors: valuation, earnings quality (growth), and momentum.
The performance of these strategies over each sideways market is shown in the table below. The top performer in these markets was always either the valuation or earnings-quality strategy, while momentum performed worst in all but one market.
What can we conclude? Markets will drift sideways at times, and there are reasons to think that broad equity indices might be range-bound. However, with a strategic focus on identifying companies offering attractive valuation with a high underlying quality of earnings, outsized returns from individual shares are accessible. In short, a sideways market is nothing to be afraid of.
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