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A Stock-picker's Dream?
Toronto: April 21, 2014
By John Stephenson

The valuation blues seem to have been relegated to the backseat this past holiday shortened week as the broad U.S. indices all rose over two percent, capturing the ground they lost the previous week.   Technology stocks recovered some of their recent steep losses, with the NASDAQ composite rising 2.4 percent for the week.  Backstopping the gains are solid economic numbers, prompting traders to speculate that the long awaited re-acceleration of the American economy has finally arrived.  Last week, capacity utilization and industrial production figures in the U.S. for Marc, showed unexpected strength, signaling a possible return to stronger markets.

There is a better tone to U.S. macroeconomic data lately, suggesting that earlier weakness really was weather related.  The more bullish view on Wall Street saw the so-called “fear gauge,” or CBOE VIX volatility index, slide by 20 percent over the week.  That coupled with strong March retail sales figures (best levels since September 2012) and capacity utilization surging to 79.2%.  Capacity utilization rates of 80% or more are historically the level where companies begin to hire and make capital expenditures, which in turn lights a fire under the economy.

So far this year, it’s been a white-knuckle ride for equity investors as previously high-flying growth stocks have taken it on the chin.  Last year’s losers have turned out to be this year’s winners, catching the market by surprise.  A rotation into defensive parts of the market, away from higher-octane growth stocks, explains in part why the S&P 500 sits 1.4% below its record close the previous month.  But despite the uncertainty, Wall Street is betting on double-digit profit expansion in the second half of the year to propel the market higher.

In Europe things are looking up with European Central Bank (ECB) head Mario Draghi hinting that quantitative easing could be coming to Europe to stave off the ravages of deflation.  The Euro has been on a tear and bond yields in the peripheral countries have dropped like stones as the ECB has signaled that they would do whatever it takes to defend the euro.

The prospect of a stronger U.S. and Europe set against a backdrop of weak quarter-over-quarter comparisons has many investors licking their lips.  Another encouraging sign for investors is the CBOE’s implied correlation measure of expected co-movements for the S&P 500’s sixty largest firms.  This important measure has been steadily declining over the last two years and despite the unrest in Ukraine and the worries over China, this reading has remained remarkable static over the last few months prompting many to speculate that this could be stock-picker’s dream scenario.

I have no doubt that the market will recover in the second half of the year and successful stock-picking will be the key factor in determining the level of returns for the balance of the year.  But simply looking at the average correlation levels between stocks on an index misses an important point.  In the past, the main argument behind the “end of stock picking” was that, as correlations rise, it becomes difficult if not impossible for investors to add value through security selection.   In other words, if every stock is moving in lockstep with one another, how can there be a payoff to security selection?  The problem with this line of thinking is that correlation itself is a measure of short-term dependence, not long-term dependence.

A study by CIBC World Markets pointed out this flaw in investors’ reasoning. Consider the performance of two gold companies, Franco Nevada and Eldorado Gold on the S&P/TSX over the past two years. Despite having an extremely high correlation of 0.75 between these two stocks, Franco Nevada managed to outperform Eldorado Gold by almost 75% over the past two years.  But yet traditional investor reasoning would suggest that the most likely outcome would be for these two stocks to move in lockstep over time. 

Why these two stocks diverged is that correlation is a short-term measure that is highly sensitive to the day-to-day noise in the market, but does little to pick up the longer-term signal or trend.  In fact, it was small levels of outperformance, just 11 basis points per day that generated the positive “alpha” or outperformance of Franco Nevada over Eldorado.

Sock picking is alive and well and likely to gain the respect that it deserves as the market remains uncertain and the “risk on risk off” swings that used to see all boats rise and fall together becomes a thing of the past.  The best opportunities for stock-pickers lie in the sectors where the average multiple is well below that of the overall market and the fundamentals remain supportive.  For my money, that’s in the Health Care, Industrials, Financials and Energy sectors.
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