Artemis’ Paras Anand says just because markets are moving sideways doesn’t mean your portfolio has to.
Inflation has finally forced central banks to tighten monetary policy and end the epic era of ultra-low interest rates. Many fear this means an extended bear market is now likely. I do not agree with you. Rather, I see good reason to believe that a sideways market is imminent. This begs the question: can you make money when the markets are essentially going nowhere?
Let’s first investigate why a sideways market scenario could be conceivable.
Much of the bear argument rests on the link between low interest rates and broad asset price increases. Higher interest rates will certainly mean falling asset prices. They will also raise borrowing costs and commodity prices, and dampen growth in western economies.
Also consider the bleak geopolitical environment and a Chinese economy weighed down by a self-imposed property bust, a zero-Covid policy and sweeping regulatory tightening.
However, there is reason to believe that given these difficulties, public markets could be well supported overall. Escalating input prices may affect profitability, but a major collapse in economic activity is far from certain.
The necessary responses to issues such as deglobalization, geopolitics and the climate and energy crises will require higher investments from government and the private sector in the future. This should help the real economy, including some very labor and capital intensive industries.
We are not entering this phase in the wake of a typical cycle of debt-financed investing and excess investing. There has obviously been a bubble in early-stage ‘disruptive’ companies, but the impact has been felt in asset prices rather than the real economy. Crucially, the financial system as a whole lacks the leverage that tends to turn idiosyncratic events into systemic problems.
Finally, it could be argued that a significant price adjustment has already occurred in liquid public markets. Of course, further adjustments may occur, but the biggest risks are probably in illiquid assets and private markets. Valuations for many public markets and securities are currently undemanding in absolute terms and relative to the past.
These opposing forces lead me to believe that we are facing a sideways market – and possibly for some time to come. This would be a notable development, not least because many investors are taking a “directional” approach. You try to profit from markets that are constantly moving up or down. Horizontal price action obviously contradicts this preference, which is why sideways markets can be challenging.
However, this does not mean that sideways markets do not produce winners. History clearly shows that they do. Legendary investors like Warren Buffett and Bill Ruane made their mark during times like this. So how should we approach markets that are inherently volatile but seemingly trendless?
Lessons in finding hidden opportunities
Robert G. Hagstrom, a well-known investor and acclaimed Warren Buffett biographer, explored this question a dozen years ago in a 2010 article entitled “Who’s Afraid of a Sideways Market?” He focused on the 500 largest stocks in the US between 1975 and 1982.
The market went nowhere during this seemingly uninspiring period, depreciating from a 12x overall gain to an average of 7x. However, some investors retained the ability to earn outsized returns.
The study found that’s because a surprising number of individual stocks in the S&P 500 — 18.6% and 38% of the index, respectively — rose more than 100% in price over rolling three- and five-year periods. Although the energy and industrials sectors had the highest proportion of gainers, there were gains across the board.
Such insights underscore the critical difference between trends within a system and trends within a system. As Hagstrom explained, most investors looked at the market as a whole and concluded that not much was happening, but the reality was that the S&P 500 still offered plenty of variation — and therefore plenty of attractive opportunities — in what was on the surface unexciting .
And who was best equipped to spot these opportunities? Hagstrom examined four investment approaches – valuation, capital and funding, earnings quality (growth), and market response (short-term momentum). Valuation proved to be the most successful strategy, while momentum – the weapon of choice in recent years – was the worst performer.
Artemis’ own analysis of sideways markets in other regions and time periods comes to similar conclusions. For example, the FTSE 350 was largely flat between March 2013 and March 2016, yet 63 stocks rose 75% or more in price over those three years.
We found that dividend yield and earnings growth (one year ahead) were the most profitable approaches in this case, with valuation being neutral and size being a negative contributor to returns. Meanwhile, dividend yield and valuation were the optimal strategies in Asia ex-Japan between July 2011 and July 2014, when 87 stocks — roughly 13% of the market — rose 75% or more in price.
An arena for active management
All of this tells us that sideways markets are less about pinning down specific sectors or themes and more about individual security picks. As Hagstrom noted, it’s about the trends hidden in a seemingly trendless system.
This means that a sideways market should present an arena in which active managers have scope to excel. The new regime should be one where the ability to smooth out market inefficiencies and price differentials could be particularly useful.
I am aware that there is currently limited evidence for this. With the old regime still unraveling, many active managers have struggled relative to the major indices. But these are early days.
If Hagstrom’s analysis and our own research are any guide, active management should increasingly come into play. The longer the consolidation period lasts, the greater the challenges in terms of asset pricing – and the more rewarding stock picking should become.
Markets can be viewed as sideways, and price movements can be directionless, at least seemingly. Ultimately, however, this does not mean that portfolio returns need to be similarly moribund.
Paras Anand is Chief Investment Officer at Artemis Investment Management