Narrower Market Leadership Makes Selection More Key

Market Leadership and Selection

The bull market marches on, but we’re seeing it being led by a small number of stocks. This means that it’s all the more important to focus on the strong and avoid the weak.

We had a banner year for stocks in 2019, but it was a year in which the banner was certainly long but it was held by only a few stocks. We’ve seen a trend more and more toward this lately, and the phenomenon is carrying over to 2020.

This is only a bad thing if you have spread things around a lot, especially if you have an aversion to the good performing stocks and have forsaken them in favor of a basket of the rest, and the rest isn’t doing that well.

Performance tends to scare a lot of people though, people like Bernstein’s Toni Sacconaghi, who has been leery of Apple for a while. He admits he made a mistake with it in 2019, thinking that it was overvalued at the time, but did not learn his lesson it seems, as he’s even more leery now, and it’s even more overvalued in his mind.

“We struggle to see more material upside from here, given that Apple is the most expensive it has been since 2010,” remarks Sacconaghi. Whether he struggles to see it or not, it is still on the move, and there might be no bigger impediment to investors than being afraid to jump on a fast-moving train because they are afraid it has travelled too far already.

Sacconaghi is far from alone in this view, but if we don’t want to ride the fast trains and these are the trains that are moving things, we’re not left with much. What people will do is continue to warn us about these things while they cling to their poorer picks and tell us things are breaking down, just because this is happening to them.

If you don’t understand that stock prices are driven by momentum, then you’re apt to be confused. If our models don’t account for such a thing because we pretend it doesn’t exist, and also ignore things like big stock buybacks that really can set stocks alight when enough momentum is present, you just won’t be able to see the phenomenon, with your limited vision.

At the end of the day, all sorts of things can happen that aren’t accounted for your limited model, which actually serves to take momentum and flip it on its head, where it’s seen as bearish when it is moving ahead, and bullish when it moves in a downward direction.

The fact that Apple is seen as something to avoid just because it has gone up so much speaks to this well, but this is but one example of our allowing us to be steered away from hot stocks because we cannot understand why they can just keep going up. If something happens that you can’t explain, and it happens often, the only real conclusion is that you just aren’t good at explaining things.

A lot of people just go with an index, which does spread things around very well, and do so without really thinking about this at all, let alone enough. You’ll buy a piece of 500 stocks with the S&P 500, but when the market goes up and almost all of the gains are due to a mere handful of them, this should be telling you that you could stand to be a lot more selective.

When it comes to being selective, the great majority of investors are completely put off by this, thinking that it is either too difficult or even a bad idea. This is certainly not for everyone, and to succeed at this, you need to leave your hang-ups at the door and let the market speak to you, rather than trying to impose your standards upon it and be disappointed when it does not conform.

Seeking to Pick the Good Stocks Provides Significantly More Opportunity

The reason why these folks did well with the S&P 500 last year is that their selection included the good stocks along with the bad, although these standout stocks did not just come out of the blue, they were for the most part stocks that were already doing well and continued to do so.

If you have an average that is going up, and a stock isn’t keeping up with the averages, this is not a bullish sign, it’s a real sign of weakness. If given the choice between going with strong stocks or weak ones, we’re going to need a very good reason to prefer a weaker one, one which is likely to propel it from a laggard to an out-performer.

For this to even happen, we need to see its momentum shift, to even have it tell us that it is ready. Even if this happens, we still need to compare its revival with the ones that have continued to do well, and the rebounding stock has to at least be in the same league with its rivals to warrant our attention.

We invest in stocks because we expect them to go up, so this should naturally have us preferring stocks that are actually doing just that over ones that really aren’t. It’s actually a lot easier to be a good stock picker than people realize, as the people who are good at this realize that the goal here is good performance so they focus on good performing stocks to pursue the goal.

If we try to complicate things too much though, or even think too much, we’re prone to get confused and lost, and this is what a lot of people do. We can take Apple for instance, where we may believe it more expensive than it has been since 2010, whatever that means, and become afraid by this.

Apple tripled in value from 2010 to 2012 though, as “expensive” as it may have been back then, so this did not turn out to be too scary, unless scary good counts. This “expensive” part cashes out to a stock having a lot of momentum, in other words being hot, and if we’re scared by this, we’ve gotten things backward.

We might think that one day, investors will wake up and tell themselves that Apple is so expensive and produce a big sell-off to bring its price more in line with what some analysts think is more fair value, but when this fails to materialize time and again, you would think that they would abandon their misguided approach. They are dug in like soldiers in a trench in WWI though, and they actually have nowhere to go since this particular type of analysis is all they know, broken or not.

When it came to selecting our top picks for 2020, all we looked at is which stocks were the hottest and also finished the year hot. As long as we understand how stocks really work, this should make complete sense. We could have made further refinements, but we wanted to show you just how simple this can be, especially since investors really need to prefer the simpler over the more complex, because the more complicated things get, the more skill is needed to interpret the results.

Among these 5 picks is Apple, a stock that has remained a star after its stellar performance last year. Apple didn’t come out of the woodwork though, and far from it, as it traded for less than a buck a share back in 2002 and has been growing at a fast rate ever since, now over 300 times what it was worth back then. This is what you call long-term growth.

We feel good about the prospects of Apple and our other picks, and the fact that it is at an all-time high and has nearly doubled over the last 12 months does not scare us, it excites us. This is because this means that the market is excited about it as well, and continues to be, as evidenced by its 5.7% gain in the first 10 days of the year. This is the amount that a lot of analysts were hoping for during all of 2020 from the indexes.

Meanwhile, both the S&P 500 and the Dow are up exactly 1%, but the part we need to realize is that both are up this much due to the performance of Apple and a few other key components. This distribution may be historically more weighted toward top performers, and whether or not this is indicative of a new era or not, this is the case now and should not be ignored.

The S&P 500 is a weighted index, and due to the fabulous performance of stocks like Apple, they are a bigger piece of the pie than they ever were. Apple now represents over 17% of the value of the index now, so while shares in the index now represent a bigger piece of the apple, we need to ask ourselves whether we would not want an even bigger piece of this and the other top performers in the index.

The Good Stocks of 2019 Continue to Do Well, and the Bad Ones Continue to Do Badly

As a little update, we wrote on both the Dogs of the Dow strategy as well as our own Top 5 Dogs to end the year, and the Dogs of the Dow is off to an inauspicious start, being down by 1.8% so far. The Small Dogs, the 5 most “inexpensive” Dow stocks as of the end of last year, are down 2.8%.

We pointed out that in 2019, the 10 lowest-yielding Dow stocks beat the 10 highest-yielding “dogs” pretty handily, and told you that this is a trend that should continue. The “reverse dogs” are also ahead handily so far in 2020, with an average gain of 1.5%, the mirror image of the losses that this lesser group has struggled with.

All 5 of our own Top Dogs are up year-to-date, with Apple gaining 5.7%, AMD up 5%, Copart showing a gain of 4.8, Chipolte Mexican Grill ahead by 2.5%, and Lam Research moving up by 0.7%. This provides us an average gain of 3.7% so far this year, a nice start to be sure compared to only a 1% market gain, and a whole lot better than losing money over this time by preferring the cold stocks like this other Dogs approach does.

A strategy like this presumes that the market will keep going forward, but given that it is, the smart money is on this continuing. If things start to go wrong, we have our 10% stops in place, so we’re not worried. Those who do not have much of a clue on how to manage risk might feel a lot less comfortable, imagining a bear market coming that has them losing even more than the average amount with stocks like this.

This can happen if we let it, but we need to ask ourselves why we would want to. Some cannot help themselves it seems, but if such a thing is not indicative of incompetence, we don’t know what is.

It has always been better to go with good performing stocks over average performers and especially poor ones, but this message hasn’t got through to everyone, or very many it would seem. It’s fine to manage our positions with a long-term view, but that’s only part of the story, as what’s going on lately does matter as well. The two do tend to be pretty well connected though, as stocks tend to outperform today because they are expected to do so in the future as well, and this is why we pay more for them now essentially.

With the trend moving more and more toward a few stocks representing the majority of the gains in an index, where the majority of moves up are caused by the top 1% of the stocks in an index, as we’re seeing with the S&P 500 these days, this makes focusing on the good ones even more important in 2020.

If we really want to capture a bigger share of bull moves, we need to be wanting to ride the real bulls, the fast running ones that are dragging most of the other stocks along with them. Index investing has the virtue of being a very simple plan, but simplicity can be taken too far, and we should instead seek something that is both simple and more effective.

We need not seek to be too fine with our selections, as the point here is to pick stocks that are doing well and avoid those that aren’t, whether that means going with just 5 of the best performing ones or hedging your bets more and just going with above average performers, or anything in between.

The most important thing to realize if we are out to capture above-average gains is that we need to seek out above average plays to best accomplish this, and avoid the below-average ones that weigh us down. This is not that hard to do at all and all you really need is the principle, where once you get this you can only help yourself by applying it in whatever manner you please as long as you are faithful to it.

While this provides us with a good basis for an entry strategy, we also need an exit strategy to go along with it, as both sides of the coin, return and risk, must be accounted for enough. We do not want to be holding Apple if the market tanks by 20% and it goes down by 40% if we’re going to use this strategy, as when we get to the point where it is no longer working, we need to do the right thing and move on to something else, which may include just getting out of stocks altogether while these storms blow over and there just isn’t the upside for us to be in them.

Very few retail investors get this, but the top pros certainly do, and this is one of the main reasons why they are top pros. Pro here doesn’t mean someone who is paid to advise you, as we’re talking about an entirely different professional, the ones that actually do it and do it so well. How they operate is not something that the investment industry wants you to know much about, because they can shepherd you much better if you remain one of their sheep and not get ideas such as managing according to performance and risk. This would set you off on your own path and the goal is to keep you from leaving their pen.

What little we are allowed to do as far as managing risk goes tends to be done in a terrible manner actually, making things worse not better by diluting our returns way too much by way of diversification and settling for far lesser returns while remaining exposed to the full measure of risk with the portion they choose to keep exposed.

Risk management, like our pursuit of returns, need not be complicated either, and the principle that applies here is that you stick with your guns as long as they continue to fire. When you run out of bullets and your wagons get circled, trying to hide in the corner of your wagon while the bullets ricochet off of it should not be the plan, as you instead need to get out of town before things get this bad and have a plan to do this.

When the party is going on, you party. When the party is over, you go home. Parties can go on for quite a while, but they also can end at any time. It is not hard to tell, because the music will stop and will be replaced by noise. The risk isn’t with the music playing, it happens when the noise replaces it, which are two distinct things. The music attracts us to the party, but the noise tells us when to go. We do need to keep our ears open to be able to tell any of this though.

Momentum investing is actually pretty easy, and can be summed up by our seeking to be in things when they are hot and out when they are not. With this becoming even more important nowadays, if we allow ourselves to become afraid of it instead, and shy away from the good stuff in favor of the less good or even bad, we won’t likely do very well, nor will we deserve to.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.