"Stock picking is a dead art form, macro themes dominate the market now more than ever." ~James Bianco, Bianco Research (Wall Street Journal, September 21, 2010)Is the age of the stock picker dead? James Bianco apparently believes bottoms up trading/investing has lost its place in today's market environment never to return again. I believe this is a wildly short-sighted view and fails to recognize the opportunity that high correlation has introduced to discriminating managers.
The rise in correlation
In the WSJ's article, the recent rise in correlation among stocks is highlighted:
Between 2000 and 2006, on average, the correlation of stocks in the S&P 500 was 27%, according to Barclays Capital. That meant that most stocks were moving independently of the index, driven more by company fundamentals, says Barclays stock-market strategist Barry Knapp...There are many reasons for high correlation in today's equity markets. Correlation typically rises aggressively in falling markets as panic drives indiscriminate selling while buying is typically much more concerted. In the last three years equity markets have seen blanket selling during panics as the crux of our problems have been manifested in debt and credit markets, the equity markets then simply seen as a risky asset class.
...Between October 2008 and February 2009, at the height of the financial crisis, correlation hit 80%, meaning lots of stocks were moving in lock step. When stocks rallied last year, the figure fell to 40%, then it spiked back over 80% during the European debt crisis, according to Barclays. What has caught many investors off guard is that correlation stayed high over the summer. In mid-August, correlation was 74%. In recent weeks, it has drifted down to 66%.
The huge growth in exchange-traded funds (ETFs) has also been a major component in rising correlation. While macro issues have always jumped into the limelight from time to time and overwhelmed the micro company picture, until recent years there was never an easy way to quickly put on the a directional macro bet. Now, for example, if a manager sees debt problems in Spain as a major problem, they can simply short the iShares Spain ETF (EWP) on the New York Stock Exchange very effectively placing a macro bet on a foreign stock market in just minutes. Add high frequency trading to the mix and ETFs and underlying equities are rapidly adjusted to changes in ETF prices.
The impacts of rising correlation
Cortina Asset Management put together some very telling charts in their 3rd Quarter Small Cap Growth Commentary. Cortina manages small cap equities and uses the Russell 2000 as its benchmark. The charts below compare the top and bottom quintiles of companies within the Russell 2000 since 2002.
These charts show that the spread between the top and bottom quintile in terms of growth is approximately 25%, near relative highs up from 21% in 2008. At the same time, the PE spread is around 7x, near relative lows and down from 16x in 2003. The primary point conveyed here is that while the top companies are growing much faster than the bottom companies compared historically, they are not receiving a valuation premium.
The opportunity for stock pickers
As investors across the spectrum throw all stocks into the same basket, opportunities arise for those more discerning. With extremely low interest rates coupled with exceptionally high cash holdings on balance sheets, the lack of premium given to better companies likely will not last. The wild bidding war for 3Par (PAR) by Hewlett-Packard (HPQ) and Dell (DELL) is a prime example of the willingness for larger companies to pay up for exciting growth prospects. 3Par tripled its market capitalization in a few weeks eventually receiving a $2.4 billion bid that valued the company at 125 times 2011 earnings.
As larger companies hold incredible flexibility to make acquisitions, investors will begin to anticipate takeovers and seek out the cheap, growing companies in the small to midcap arena that the market is undervaluing. The age of the stock picker is far from dead. Indeed, now is probably precisely the time investors should be seeking out values as other market participants ignore the possibilities in discovering the hidden gems.
Brandon R. Rowley
"Chance favors the prepared mind."
*DISCLOSURE: Nothing relevant.