So much for those stock market “melt-up” forecasts. Bloomberg (“Hold Tight for Volatility as Trade Turmoil Rattles Markets Anew”) and The Wall Street Journal (“Volatility Could Cause More Pain as Funds Betting on Quiet Sell Down Stocks”) now warn of volatility’s return producing “Turmoil!” and “Pain!” However, investors should welcome the increased volatility, not fear it. It is a sign of normality returning, plus the increase is far from extreme, as shown here…
The stock market’s performance over the first four months of 2019 may have been excitingly up, but the specific stock actions generally were unremarkable and dull. Take away the earnings report bumps/dumps and the one-off events (like Boeing and Qualcomm), and what remained were correlated moves, usually based on current, soon-to-be-forgotten issues.
Disclosure: Author is fully invested in stocks and stock funds, including Qualcomm and Vanguard Explorer Fund
Blame those four months on two drivers
- First, the popularity of top-down investing (focusing on the economy, overall market, sectors and industries, as well as popular beliefs and generalized trends)
- Second, the widespread use of index investing, including index-based ETFs – as money flowed in, all stocks in the index were bought
Conversely, active investors’ and investment managers’ bottom-up investing approaches (focusing on individual companies) were generally out of favor.
All-time high stocks provided the proof of abnormal languor
An especially clear sign of the four-month dullness was the inaction of stocks making all-time highs. Virtually all of the 1,000+ stocks reaching new high levels did so without fanfare. Instead, they simply drifted into new high territory, followed by more drifting: up, sideways and down. That behavior is highly unnatural.
Normally, a stock’s initial move to a new all-time high (not as part of a trend, but as a breakout over a previously established high) comes with increased trading volume and volatility. The cause is the change in investor attitudes that occur once a stock rises above its historical high. At that point, all stockholders have a profit, and no one is holding on to break even. Moreover, with no upside barriers hovering above, speculators get excited about the boundless opportunity. Then there is the naturally shifting views of investors: the value-oriented see valuations lessening (sell?), and growth-oriented see improving expectations (buy!). The result: Actions are taken, with trading volume and price volatility rising.
And that is where the month of May comes in…
May 2019 – Stock investing looks to be making a shift to active from passive
This month, the stock market’s dynamics have suddenly shifted. Three of the drivers of the increased volatility could be preludes to a revamped bull market:
- First, intraday reversals of simplistic moves. Last week’s actions contained many seesaws, capped off by the sizeable reversal on Friday. What is the cause? It looks like there is an underlying, bottom-up support coming into selected stocks whenever the top-down, Trump-tariff-trade crowd hammers the market in general.
- Second, all-time high stocks are suddenly showing their historical characteristics of heightened trading volume and price volatility. From zero all-time high stocks during the first four months, my selected list has suddenly grown to over twenty. Over the past 55 years, I have tracked all-time high stocks, and such heightened activity usually precedes good stock-picking times in the market.
- Third, small company stocks are ripe for a catch-up and pass move vs. the index-heavy, large company stocks. The smalls lagged the first four months, not because of weaker fundamentals, but because of the favored top-down, index-focused investment schemes. Seeing and acting on such popularity shifts is the objective of Wall Streeters, so today’s subtle signs could blossom into a full-blown trend – one where stock picking and active fund management once again outperforms passive indexing. Here is the picture of how the Russell 2000 (small company stock index) has lagged virtually everything…
The bottom line
The stock market is acting up, making volatility rise. This change means the top-down, index-focused investment strategy of 2019’s January-April rise could be over. Replacing it could be the historically sound bottom-up, stock selection strategy. Importantly, there are many approaches (called investment styles) practiced by skilled active investors and investment managers. This means normal volatility likely is returning, and that is a good development, not a concern.
Therefore, now is the time to pull out your stock selection and actively-managed mutual fund books to sharpen your investment strategy to match the new stock market ahead.
A final note: Fight the trend because it will end
Find it hard to believe that active management can actually outperform passive? After all, index funds are less expensive, less risky and always outperform – right? That is a popular trend talking, but it will reverse. The cycling between passive and active being “best” has been around since the onset of index funds.
So, be contrarian. Have faith in the ability of experienced investors being able to outperform, especially when the stock market gains volatility and generalized market performance pales in comparison to what smart managers and investors are able to achieve. A good example of the weak short-term and strong long-term view of active management is the Vanguard Explorer Fund…