How do you pick stocks?
(This is a big, complex topic. So this post is both a bit longer than usual and painted with a broad brush.) If you do stock picking for a living, you’d better have an answer, and it had better be good. Honestly, though, my impression is that I wouldn’t be very impressed by most of the answers of professionals.
It’s a common sentiment to say the market is driven by fear and greed, but how does that work, really? In that sense, looking at something like Twitter can be pretty informative. People are generally reacting to what happened over the last few days. If the recent trend has been good, people get all bulled up, expecting the excitement to continue. If it’s been bad, people are scared of what’s coming down the pike (though I admit that people are generally of a bullish nature). If a trend goes on long enough, then everyone seems to believe that “stocks can’t go up” or “stocks can’t go down.”
That still doesn’t answer the question of how people pick stocks, but I think we’re getting closer. Fear and greed seem to affect most managers, but how does that get implemented? My impression is that many are essentially gamblers, and not very sophisticated ones at that. They operate on a good ‘feel,’ or look for a ‘good run’ or a ‘hot hand.’ An implication of that is a lot of managers are essentially trend followers and technicians. A lot of things can appear to work, or seem to work for a while, but this strikes me as a poor philosophy for the long run. It is important to know whether your stock picking approach matches up with your investment time horizon.
Fortunately, I’m an alien. I learned a long time ago that there are many times when acting or reacting emotionally isn’t helpful. Better to stay calm and think. This got driven home when I first became a portfolio manager at the start of 2000. At the time, the stock market was all about growth, particularly tech, media, and telecom. Stocks didn’t go down anymore. Value buyers were dinosaurs – the world had passed them by. Then in March all that changed dramatically. We at SCM were fine, because we hadn’t joined the herd in jumping off that cliff.
So how do we do it?
I think repeatable results come from having a process. There is a reason casinos are a good business — gambling is a net-losing proposition. To be fair, stocks aren’t so grim, but I believe all that difference does is give the stock gamblers more cover. If you’re making 8% a year over time, at least you’re making money, albeit not as much as the 10% in the market. Since it’s a noisy 8%, you can sell your fund hard while it’s going relatively well, then try to hold on to it when performance isn’t so great.
We think we can do better. We have a general philosophy, which is basically to get rich cautiously. We really like stocks when nobody else likes them, because that’s when all the marginal buyers are gone and all the bad news is priced in. The problem with that strategy is that it doesn’t work all the time. What if, like now, everything is loved? Bonds are up, stocks are up, it’s a fiesta everywhere. We have an answer for that in our quantitative macro work.
When I first used macro work in 2002-3, it was qualitative in nature. How do things look generally? That worked fine until central banks started to have a heavy influence on markets, starting in 2009 but really becoming evident in late 2011. At that point we worked on adding a more quantitative process, which has the bonus benefit of working in all conditions, including times of central bank interference with the markets. It’s basically the same way we look at a stock. Are things likely to get better or worse? With this process of macro modeling and stock picking, I don’t think we’re perfect, but I do think we’re likely to be better than the vast majority of managers over time.
Let’s look at how this works right now versus how most managers seem to work. Economic growth has been trending down for a while now, and there’s no sign of that changing anytime soon. Thus, we’d say economic growth is slowing. What works in that situation? Historically, the consumer staples and utilities sectors work best at these times, so that’s what we’re focused on. Looking at many managers, they seem to just take the latest newsy item and run with it, especially if they can make a narrative with it. The latest example seems to be financials. The narrative is ‘the Fed is going to raise rates.’ Sounds good, right? So run with it!
I think that’s exactly wrong. I think instead of making a narrative, you should look at what drives sectors, stocks, and markets. In this case, the most basic way financials make money is the yield spread. In general, banks loan money over the long-term, and borrow in the short-term. Thus, when the yield spread is high (or steep), or getting steeper, banks are making money, or have prospects to make more money. Conversely, when the yield curve is low (flat), there’s not much of a difference between funding costs and lending income, so their ability to make money is compressed. Right now the yield spread is low, and has only become flatter since Jackson Hole. Thus, as part of a process, it makes no sense to buy financials right now. Their business is lousy and there’s no sign of it getting better.
What if the narrative guy says, “Wait! Everybody knows the 10Y Treasury yield is going up! That’s why I’m buying financials! You have to buy financials when rates are going up!”
Really? Is that how it works? Let’s look at causal factors. The short-term rates are very much correlated to Fed funds rates and expectations for those rates. If the Fed is raising rates, short-term rates will rise. If more hikes are expected, rates will be higher further out in time. How are long-term rates priced? The highest correlation is with economic growth. When growth is rising, Treasuries’ prices fall (yields rise) as people are optimistic on the economy and want to invest more aggressively. When growth is falling, people get more conservative and want safe assets. Thus, with growth slowing and the Fed talking about raising short-term rates, you should expect the yield curve to flatten, which is bad for financials.
It’s true that rising rates and rising financials tend to go together, but they’re not causal. It just happens that generally the Fed is raising rates because the economy is doing well and they want to keep it from ‘overheating.’ That isn’t the case here – growth has been pretty anemic for a while. The actual causal factors were described above, and they spell trouble for financials. Narrative-guy can choose to disbelieve me – that’s what makes a market. The thing is, we have a great example of what I’m talking about, because this setup and resolution already happened last December when the Fed last raised rates. How did that go?
In the fall of last year, the Fed started to talk up raising rates. The same narrative outlined above took place, with people deciding to sell utilities and staples and favoring things like retail and other bullish sectors. That lasted until the Fed actually raised rates. That event did exactly what we said it would do – it lowered bond yields and compressed the yield curve. The market dropped 15% in short order, while the growth-slowing sectors outperformed by a large margin. Why should anything different happen this time? I’d argue it will probably be worse – we’ve already raised rates once, so we’re already compressed. Fundamentals have been getting worse and the market is more expensive. Narratives can work sometimes, but they can also blow up. This market narrative (economic improvement and buy everything) strikes me as particularly dangerous right now. I’m much more comfortable with our analysis. I don’t need to win every day or week, I just want to win over time without undue risk, which is why I think we’re much better positioned than most.