Stock Pickers Aren’t Dead Just Yet

Herb Greenberg has a great column on the last of a dying breed, the stock-picker — a group that includes yours truly. I admit that the machines are much faster than us, but we humans still have many advantages, namely the irrationality of our fellow humans.
Despite the hand-wringing, this has been a very good time to be a stock-picker. Let’s look at the Rydex S&P 500 Equal Weighted ETF (RSP) compared with the S&P 500 Spyders (SPY):

In other words, the average stock has beaten the index by a good margin.
Will this divergence continue? It’s hard to say. I think one factor that will help is the persistence of low inflation, if not deflation.
When the pricing environment is so hostile to price increases, this may place a greater premium on companies that are more efficient or that offer something unique. The more diversity there is in rewards, the more opportunity there is for stock-pickers to find above-average profit opportunities.
When anybody can make a buck, anybody will and then you’re much better off going with the indexes.
What’s also going on right now is that many equity classes are correlating with one another. This means that if the drugs stocks go up, say, 1% one day, then the tech stocks are also going up by about that amount.
When the stock groups behave too similarly, it gets hard for money managers to set themselves apart — and that’s how they make their money. They want to see lots of divergences.

“That’s not a healthy market. The mathematical benefits of diversification require assets that exhibit low-to-no correlation amongst themselves. When everything moves in synch, asset allocators have to pull in their horns,” Colas writes. “Wonder why investors are shunning risk and buying bonds? Part of the reason is clearly that the historically proven benefits of diversification just are not working as well as they once did.”
Within the stock market, the Sector SPDR family of ETFs that carve up the S&P 500 offers a striking example of the herd behavior.
“U.S. equity correlations among the 10 industrial sectors of the S&P 500 remain near historical highs, as 7 out of the 10 sector ETFs show correlations with the S&P 500 in excess of 90%,” according to the strategist. “Only Healthcare (XLV), Utilities (XLU) and Consumer Staples (XLP) are lower, and they’re stuck in the 80% range, which is still very high.”

I disagree that this is “dangerous.” It just means that alpha isn’t so easy to come by.

Posted by Eddy Elfenbein on September 16th, 2010 at 11:57 am

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