Stock picking: not dead, yet

In my most recent client letter, I had a section about the death of stock picking.

I highlighted that correlations between stocks within the S&P 500 have been very high with the index itself, particularly since late 2007.  

This means it's been very hard to pick stocks that beat the index, because if almost all the individual stocks in an index march in lock-step, it's going to be very hard to beat the index.

There's been a lot of speculation about why high correlations occurred. One theory is that Exchange Traded Funds (ETFs) have taken over for individual stocks as the investment vehicle of choice. Another theory is that high-frequency traders have caused all stocks to trade together. Still another is that markets have been moving in sync because everyone is scared out of their wits since markets and economies started tanking in 2008.

None of these explanations seem satisfactory.  

If ETFs were the cause, then wouldn't stocks have marched in lock-step with the advent of the index fund, or highly diversified mutual funds? No, that didn't really happen.

How about high-frequency traders? If that were ultimate cause, then each advent of new, faster trading technology or smaller decimal trading would coincide with higher correlations. Again, not so much.

As for the fact that everyone is scared? Is that really new? Does anyone really think that recent events are scarier than World War I, Spanish Flu, a world-wide Great Depression, World War II, the threat of nuclear annihilation, or Boy George?  

If markets didn't become and stay correlated at those points, why would we expect them to have done so now?

And, that was the point I tried to make in my client letter: that high correlations are not that unusual, and they have always ended as abruptly as they've begun.  

Lo and behold, correlations of stocks within the S&P 500 tanked in January and my clients beat the market by 4% (on an absolute, not annualized, basis) that month.

Did something suddenly change? Did Europe's problems go away? Did the U.S. fix its government debt? Did Japan's economy recover? Has China avoided a hard landing? No, no, no, and no.

Were ETFs eliminated? Did high-frequency traders all go on vacation? Are people no longer scared? No, no and no.

So, why the change? I don't know, and I don't really care.  

Successful investing isn't about reading tea-leaves and guessing future turns in the market, it's about investing in individual businesses that you understand at low prices and then holding until short-term-oriented investors recognize underlying value.

The attempt to explain and predict crowd psychology has been--and always will be--a dead-end.

Will correlations stay low? I have no idea about the short term, but I'm certain high correlations will come and go over time. Will my clients and I retain our gains?  Again, I don't really know.

But, that's no barrier to long term investment success.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.