Small stocks have lagged their larger peers over the past decade. But does that mean the “small-firm effect” is dead? Not exactly, says Mark Hulbert in a recent Barron’s column.
Many investors are fearing that the recent tumble in oil prices is a sign of bad things to come for stocks. But Mark Hulbert says sentiment levels indicate that the bull market isn’t done.
Investors often pay lots of attention to who a company’s CEOs is, or should be. But MarketWatch’s Mark Hulbert says they are probably wasting their time.
“In fact, according to Rakesh Khurana, a professor of leadership development at Harvard Business School, a corporation’s internal culture ‘exerts a far greater longer-term influence on the company’s success’ than a CEO,” Hulbert writes. “’Large-scale statistical studies have failed to find any direct causal link between CEOs and firm performance,’ he told me.”
Hulbert says that culture is difficult to quantify. “But one academic study found that a good measure of corporate culture is responsiveness to shareholder concerns — as measured by the presence or absence of governance structures that enable or prevent shareholders to effect change,” he writes. “That study, by Andrew Metrick of Yale University, Paul Gompers of Harvard University and Joy Ishii of Stanford University, found that the shares of companies that were most responsive to shareholders gained an average of 8.5% more per year than companies that were the least responsive.”
MarketWatch’s Mark Hulbert says that stock market sentiment has recently reached “dangerous proportions”, but also says that means little for longer term market performance.
In a recent column, Hulbert said that the average level of equity exposure among a group of market-timing newsletters he monitors through Hulbert Financial Digest was at nearly 94%, a level that, when reached, has been accompanied almost every time by a short term peak or near-peak in the Nasdaq Composite Index in recent years. “But notice also that, after each of those recent pullbacks, the market’s uptrend resumed,” Hulbert added. “It would have been a bad idea for someone on any of those prior occasions to have declared the bull market over and gone completely to cash.”
Hulbert analyzed historical data and found that up until about ten years ago, sentiment data “had its greatest explanatory power at the three-month horizon. That’s a short enough horizon already, but it has shrunk in recent years — and is now little longer than one month.”
Hulbert says the recent overly bullish mood “now tells us little more than that the market is vulnerable to a short-term decline lasting little more than a month — maybe three.” Sentiment won’t cause a new bear market, he says.
Earnings often dominate the investing headlines, but according to a growing body of research, a better indicator of future stock returns may be gross profitability.
The research focuses on gross profits because “a company’s earnings reflect myriad factors having nothing to do with how profitable it is likely to be in future years, says Robert Novy-Marx, a finance professor at the University of Rochester,” Mark Hulbert writes in a MarketWatch column. He says Novy-Marx divides gross profits by total assets in order to compare companies of different size. Research has found that historically, firms in the top 20% percent of the market on that basis have outperformed those in the bottom 20% by 3.5 percentage points annually over the next year.
Hulbert warns not to put all your eggs in one basket, however, noting that valuation is always important. In fact, Novy-Marx has found that the most-profitable companies with the cheapest valuations have outperformed the least-profitable companies with the highest valuations by an average of 7.4 percentage points a year.
While stock correlations have been declining, several researchers say that doesn’t make the current environment any better for stick pickers — whose odds of success remain exceptionally low.
“One factor that has a big effect on stocks’ sensitivity to movements in the overall market: changes in the market’s overall volatility, as measured by benchmarks like the Chicago Board Options Exchange’s Volatility Index,” Mark Hulbert writes in a recent MarketWatch column. ” Yet those fluctuations don’t mean there has been any real change in stocks’ relationships to the overall market, according to Kristin Forbes, professor of management and global economics at MIT’s Sloan School of Management. ‘It’s an artifact of the statistics that any time volatility decreases, correlations decrease automatically as well,’ she says.”
Hulbert adds that, “in addition to low market volatility recently, another reason why stocks have been acting more independently of late is that the pendulum has swung so far away from the fear end of the spectrum.” As fear increases, stocks tend to move more in sync with each other, he says. “The investment implication: Stocks — at any time and with no warning — could once again begin moving in lock step with the overall market. As a result, stock selection has no greater odds of success now than at any other time.”
Unfortunately, those odds are quite poor, he says. One researcher tells Hulbert that “less than 1% of individuals who trade frequently can consistently outperform the market through skill. Over the long run, the rest would be better off investing in low-cost index funds benchmarked to the broad market.”