Why Avoiding the Herd is More Important than Ever

Fiona Clark, 3 July 2012

Macquarie published an interesting piece of research this month, entitled “Australian Quant Action: A stock picker’s pickle”, which shows that the challenge for stock pickers is higher than ever – Tony Featherstone provides a good summary here.

The research found that ASX 200 stocks are now moving more closely together. Macquarie studied the correlation of each stock’s return in the S&P/ASX 200 index to every other stock’s return, using a year of weekly returns. Correlation measures how closely things move together, with a correlation of 1 meaning stocks move up and down perfectly and a correlation of zero suggesting there is no linear relationship.

The findings indicated that the correlation has moved from 0.25 to almost 0.40 in less than a year and is the highest in 20 years. This means that share prices are moving together quite closely – everything up one day and down the next. We all knew this of course, but now we have the statistical proof!

Why? It could be any of:

  • Negative equity market sentiment – when everyone is nervous, they tend to move like a herd
  • High volatility – related to nervousness and other trading-based factors
  • Macro or thematic trading – if global growth assumptions are adjusted, then all the affected companies (which means virtually everything!) move in the same direction

While there are many suggested reasons behind the increased volatility of markets and the increased correlation of stocks, let’s focus on a couple of the key issues

  • Will it last?
  • What can an investor do to avoid “market” returns, particularly if you’re not that confident about the market?

The study suggests that the correlation in ASX 200 stocks spikes in periods of market volatility (such as during the GFC and the Asian financial crisis) and falls again when the volatility subsides. So if you suspect, as we do, that volatility is likely to continue, then trying to “pick” stocks might require a different approach. Choosing companies with solid fundamentals becomes a challenge when companies are moving together so closely, with returns dominated by macro themes and the global risk appetite or statements from bureaucrats and politicians.

A less than satisfactory approach is to keep all your assets in cash, as while this may deliver less variation in your investment portfolio balance it is hardly a sensible way to plan for retirement with a potential loss of purchasing power and little in the way of income in a falling interest rate environment.

Another option is to tough it out. Pick those good quality companies to your heart’s content, buy them when they get dragged down with every other average run-of-the-mill enterprise, and when volatility eases, benefit as the true value of your quality investment is appreciated. This is a pretty smart strategy, and one that we try and take advantage of, but the downside is in the timing. This strategy requires a bit of patience for the dust of high volatility and high correlation to settle.

The third option is to try and add something from outside the ASX 200 into your portfolio. Something LESS correlated. These companies are often overlooked by larger managers, hedge funds and high frequency traders, so their valuations are often a better reflection of the basic fundamentals, allowing for the normal pricing anomalies. Smaller companies often have greater flexibility in their operations and can drive above average growth, even when the underlying macroeconomic environment is weak. They can also be quite simple and easy to understand, rather than large conglomerates with layers of complexity. And smaller companies generally deliver higher returns when markets rebound.

While investing in smaller companies is not without risk, the risk profile hasn’t changed much; whereas for larger companies, even quality large companies, it has increased substantially. We think it’s a good idea to think outside the ASX 200 “box”, so to speak, and broaden your investment universe. It may mean your portfolio moves more in line with things you understand and expect.

It’s certainly easier than trying to become the ultimate expert on European politics, Chinese steel production and US fiscal cliffs!