We’ve all heard a manager complain about narrow markets. We are guilty of it ourselves. What is a narrow market and how do we view it in the context of recent equity performance? In our view, a narrow market occurs when a small subset of stocks dominate market returns over a given period. Recently, FANG’s have dominated much of the conversation in our meetings with managers. FANG’s (Facebook, Amazon, Netflix and Google) dominated the market in 2015 with an average return of 83%. They alone accounted for 190 basis points of the S&P 500 performance in 2015, meaning the remaining 497 index constituents combined to detract roughly 50 basis points from the final index return. In 2015 the S&P 500 returned 1.38 percent while the equally weighted S&P 500 returned -2.20 percent. When the equal weighted index diverges significantly from the cap weighted index it is often the result of several large stocks dominating returns. JP Morgan recently stated that 2015 wasn’t necessarily a narrow market, but what was different was the magnitude by which many stocks underperformed. The easiest explanation for this is to look at sector returns. Energy and Materials stocks, along with multinationals weighed down by a strong dollar, all experienced outsized negative returns, thus impacting broader averages negatively.
Factor performance was also heavily skewed to a small subset of indicators that worked in 2015. According to Barra analytics, Momentum exposure was far and away the best performing factor in 2015. In layman’s terms, when Momentum outperforms, it indicates the best strategy to employ is one that buys past winners. Conversely, Volatility and Beta were among the worst performing factors in 2015. Value, buying cheap stocks, is one of the strongest and most reliable long term positive factors driving equity returns, but it likewise yielded to Momentum in 2015. Value investing underperformed Growth by over 800 basis points in 2015, and is nearing underperformance levels last seen during the tech bubble of the late 1990’s.
We often ask managers what environments favor their style and in what environments they will underperform in. The vast majority of active managers with a bottom-up process would describe “momentum-driven, narrow equity markets” as environments they would underperform in. 2015 was just such a market. Interestingly, in a recent conversation with a quantitative manager we employ, it didn’t help to be exposed to momentum if you were a value manager. As the below chart depicts, 2015 was quirkier than originally thought. Momentum only worked if you were employing it as a strategy within a growth universe. If you were using momentum as a factor in a value universe, you weren’t overly rewarded. Conversely, only in value universes did “low volatility” work. If you employed that strategy in a growth universe, you would have been better off in highly volatile stocks.
The negative markets in January of this year were more of the same from a top down standpoint, although we may be seeing the start of momentum underperforming in the early days of February. All of these anecdotes on their own make for interesting reading, but taken together, we believe they paint a picture of the current state of the equity market. Years of excess liquidity have driven a flows dominated environment, and flows have been going to strategies that can best fit a “top-down” point of view of the world, often implemented by smart beta strategies and ETF’s. What gets left out in all of this is the underlying fundamental value of individual companies, best exploited through active management.
These periods are never fun to go through when you employ active managers, but the good news is they do pass. They may go on longer than you think they should, but when markets rotate, they often do so quickly and forcefully. So what is it that we expect next? Value outperforming growth; mean reversion outperforming momentum; equal weighted outperforming cap weighted and active outperforming passive. While it’s impossible to time market rotations, patience is usually rewarded in awaiting a return to fundamentals.