Will 2015 Be A Stock Picker's Market?

We may have our favourite stock pickers who have done well in the recent past, but they are the exception rather than the rule.  In the UK, Neil Woodford and Richard Buxton are often cited as outstanding managers.  However, the average active manager has had a tough time, which has led to the rapid growth of index investing and of ETFs in particular.

Rising interest rates gives small caps a boost

Joseph Mezrich, managing director at Nomura Securities, produced an insightful research note in December 2014 looking at the period from 1962 to 2014.  This showed that historically stock pickers have done well in an environment of rising interest rates.  Mezrich suggests that rising interest rates are often indicative of improving economic activity. This is turn tends to be good for smaller stocks, typically the place where active managers add value against a cap weighted benchmark.

This research is only on the U.S. market, but I think it is intuitively correct for the wider equity market.  Good stock pickers will typically have a bias towards smaller, faster growing companies and bet against the slower growing, large cap stocks that make up the bulk of an index.

Falling correlations will help stockpickers

Another widely remarked feature of the past few years has been the “risk-on / risk-off” environment as we lurched from one crisis to another.  A quantitative analyst would say that “cross sectional correlation of stocks have been high”.  That is if the market goes up over one day, then all stocks are likely to go up that day and vice versa.  When all stocks move together it is very difficult for stock pickers to add value.  This led some commentators to suggest that diversification no longer worked.

There is some truth in the idea that diversification has not worked well recently.  The cross correlation of stocks shot up in 2008 and has remained elevated since.  It only started to creep down as the last Euro crisis subsided.  When cross correlations are high, it is very hard for stock pickers to do well.  Active managers can try to time the market, but most avoid it and remain fully invested as their skill is stock selection.  However, as correlations drop I believe stock pickers should start to do better.

Market breadth might broaden

The idea of falling correlations brings me to my final related point – Richard Grinold’s The Fundamental Law of Asset Management. This is the idea that a stock picker’s risk-adjusted return is a product of his or her skill and the number of different thematic bets that can be made in the market over a period. Grinold calls this market breadth.  The wider the market breadth, the more opportunities active managers have to make their own bets and diversify their portfolios. Many have noted the fall in market breadth and have plausibly suggested that one of its causes might be quantitative easing (QE).

A good example where market breadth has been very narrow is the Japanese market which is being driven by the value of the yen.  You should perhaps consider selling your currency hedged Japanese ETFs and buy a stock picking fund when the link between the Nikkei and the yen breaks down and the market breadth broadens [when there are more opportunities to make independent bets in the market], although we may have to wait for the end of QE in Japan before this happens.

A new era for active managers

I have argued that the period since the financial crisis has been a particularly tough one for stock pickers with falling interest rates, high cross correlations and the lack of breadth all contributing to their relative underperformance.

The early weeks of 2015 are hardly off to a great start, with investors worrying about the oil price and the situation is Greece.  However if the market can overcome these problems, 2015 could be a great year for stock pickers and the start of a great era for active management as conditions normalise.  Economic growth may lead to the end of “risk-on / risk-off” and the market breadth may return, all of which may help stock pickers to challenge the growth of the ETF.

Peter Sleep is a senior portfolio manager at 7IM