Good News for Stock Pickers
Thursday, August 22, 2013
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Diversification: A Failure of Fact or Expectation?
Low correlations cushioned prior declines.

How to Achieve the Right Asset Allocation
Focus on allocation more than stock selection.

AAII Discussion Boards
Are you now doing more or less stock picking?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 29.0%, down 5.5 points
  Neutral: 28.2%, down 9.1 points
  Bearish: 42.9%, up 14.7 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

As you may have heard, trading on the NASDAQ was halted for a few hours today. If you placed a buy or sell order today, I would suggest contacting your broker since it is unclear as to which trades will be canceled and which won’t be as of the time of this writing.

The overwhelming majority of trades get processed without any problems. Unfortunately, due to the complexity of the financial system, disruptions do occur. Though frustrating, understand that your biggest risk is still inflation and not an intraday trading disruption. Nonetheless, days like today should serve as a reminder to use limit orders and not market orders when placing a buy or a sell order.

The decline in correlations has become a trending topic among stock market strategists. The monthly returns of individual U.S. stocks are diverging from the Russell 1,000 index. Depending on who you ask, this is either a positive occurrence for stock pickers or a sign that fund managers are becoming complacent.

Correlations measure how closely the returns of two investments mimic each other. The closer a correlation value is to 0.0, the greater the difference in returns is. The closer a correlation value is to 1.0, the more similar returns are. Correlations can be as low as -1.0 when return characteristics are opposite of one another.

During bear markets, correlations among individual stocks rise towards 1.0. (Correlations across asset classes and geographic markets often rise too). As the level of fear and discomfort rises, investors opt to sell everything rather than selectively look for opportunities. During bull markets, correlations among individual stocks fall as investors become more opportunistic and selective.

Right now, we’re seeing correlations fall. On Sunday evening, The Wall Street Journal reported, “Stocks in the Russell 1000 index of large-capitalization stocks had a weighted average correlation of 0.30 to the index itself, the lowest for an end-of-month since 2007 and down from 0.57 a year earlier, according to Deutsche Bank data.” This decline is not surprising given the length of the current rally. Institutional investors are emboldened by the rise in stock prices and are more inclined to take security-specific risk.

Whether this is a good thing is a topic of debate. On the positive side, the falling correlations indicate there are opportunities for investors to beat the market. We can see this with the performance of the AAII Model Shadow Stock portfolio, which is up 44.4% year-to-date through July 31, 2013. On the negative side, it suggests institutional investors are less fearful. Citigroup’s Tobias Levkovich says the reduced correlations among stocks is a sign of complacency. Business Insider quoted him as opining, “Investors might be overly focused on stock picking and have begun to ignore broader influences such as Fed policy, market valuation, European growth trends, economic surprise indices and the like.”

I think the lower correlations are good news for stock pickers. The decline makes it easier for those who can find quality stocks to beat the market. (It does not guarantee you will, however.) I also think what we are witnessing is simply an occurrence of normal market cycles. It is natural to expect correlations to fall as a bull market lengthens in time, just as it is natural to expect correlations to rise when the bear wakes up from hibernation.

The problem with focusing on changes in monthly correlation is that you will find yourself jumping back and forth between active and passive (index) strategies, which needlessly increases transaction costs and will drive you nuts. I think the better strategy is to view changes in monthly correlations as interesting, while sticking with a mix of individual stock selection and indexing that makes the most sense for you.

More on

The Week Ahead

We are entering a lull for earnings news with just a handful of S&P 500 companies reporting next week. Those companies are Tiffany & Co. (TIF) on Tuesday; Joy Global (JOYG) on Wednesday; and Campbell Soup Company (CPB), Pall Corp. (PLL) and (CRM) on Thursday.

July durable goods orders will be the week’s first economic report, with a Monday release date. Tuesday will feature the Conference Board’s August consumer confidence survey and the June Case-Shiller Home Price Index. Wednesday will feature July pending home sales. The first revision to second-quarter GDP will be released on Thursday. Friday will feature the final August University of Michigan consumer sentiment survey, July personal income and spending, and the August Chicago PMI.

Three Federal Reserve officials will make public appearances. San Francisco president John Williams will speak on Tuesday. Richmond president Jeffrey Lacker will speak on Thursday. St. Louis president James Bullard will speak on Thursday and Friday.

The Treasury Department will auction $34 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

Bearish sentiment rose by 14.7 percentage points to a four-month high as both bullish and neutral sentiment fell in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 5.5 percentage points to 29.0%. This puts optimism near the bottom of what has historically been the normal range of readings. It is also the third time in four weeks that bullish sentiment is below its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, plunged 9.1 percentage points to 28.2%. This is the first time in 13 weeks that neutral sentiment is below its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, spiked by 14.7 percentage points to 42.9%. This is the largest weekly increase in pessimism since April 11, 2013. The historical average is 30.5%.

Pessimism is now at an unusually high level following the second large jump in bearish sentiment this year. On April 11, bearish sentiment surged by 26.3 points to 54.5%. After the April jump, pessimism pulled back over next four consecutive weeks.

Bearish sentiment has been rising recently, with this week’s increase marking the sixth consecutively weekly increase. Until this week, neutral sentiment had stayed in a relatively high range. Combined, these trends signaled a growing sense of cautiousness on the part of individual investors. The 2.5% decline in the S&P 500 over the past five days may have been the catalyst to move some AAII members from the neutral camp and into the bearish camp. Current market valuations, the possibility of the Federal Reserve tapering its bond purchases, a lack of progress on key issues by Congress and the president, and slow economic growth are all dampening investors’ moods.

This week’s special question asked AAII members how second-quarter earnings influenced their outlook for stock prices. Nearly four out of 10 respondents (39%) said their outlook was not altered by the quarterly results. About 17% said the quarterly reports caused them to become more bearish. The responses from other individual investors were mixed some respondents with saying they are now more bullish and others saying they are more concerned with the potential near-term tapering of bond purchases by the Federal Reserve. A few respondents said their investment outlook is not influenced by quarterly earnings.

Here is a sampling of the responses:

  • “No change in my outlook, but I was disappointed in second-quarter earnings”
  • “Earnings were not very good, but I’m more concerned about rising interest rates.”
  • “Earnings and corporate outlooks point to steady, but slow growth in the economy over the intermediate term.”
  • “Positively. I was pleased with earnings of the companies I hold for the most part and was pleasantly surprised by the overall outlooks from most companies.”
  • “Very little change. There were few surprises.”

» Take the sentiment survey