It's A Stock Picker's Year

| About: SPDR S&P (SPY)

It's been a great year for the market, with the S&P 500 (NYSEARCA:SPY) closing on November 14 at a new all-time high of 1790.62 -- the 35th time its set a new high this year (Note that from 1930 through 1953 there were no new closing highs). That puts the total return of the S&P 500 at almost 28 percent.

In addition to it being a great year for the market, it should be a great year for active managers -- those stock pickers who every year are seeking alpha -- as the stars certainly appear to be aligned for them to outperform. Let's see why this is the case.

First, the correlations (a measure of the strength of the linear relationship between two variables) of stocks has fallen dramatically this year. In recent years, a common excuse for the failure of active managers (those stock pickers) had been that the increased correlations of stocks made it difficult for active managers to outperform. In other words, it wasn't a stock picker's market as prices were being driven by big macro issues that impacted all stocks in a similar manner. With falling correlations, stock pickers can now shine.

Second, there's been a huge dispersion of returns among stocks this year. While the S&P 500 was up almost 28 percent for the year, take a look at these opportunities for stock pickers to outperform:



Best Buy (NYSE:BBY)


Micron Technology (NASDAQ:MU)


Delta Airlines (NYSE:DAL)


GameStop (NYSE:GME)


Pitney Bowes (NYSE:PBI)


TripAdvisor (NASDAQ:TRIP)


Boston Scientific (NYSE:BSX)


First Solar (NASDAQ:FSLR)


All a stock picker (active manager) would have had to do is overweight these stocks and you would generate huge alpha. What more could an active manager ask for?

Those of you familiar with my books and blog posts know that whenever I'm asked for a forecast, be it about the economy or the market, my answer is always the same: Sorry, but my crystal ball is cloudy. However, this is one case where I'm going to stick my neck out and make a definitive forecast. As sure as the sun rises in the east, at the end of the year, active managers will be providing another excuse for their failure. And just like their other excuses, the new one won't hold up to scrutiny either.

Exposing the Excuses

Let's take the correlation excuse first. Correlation shows the directional movement of stocks, not the magnitude of their movement. Magnitude is shown by the dispersion of returns - the size of differences in the returns of individual stocks/asset classes. The greater the dispersion, the greater the opportunity for active management to add value by overweighting the winners and avoiding the losers. Thus, it's the dispersion of returns that we should look at, not the correlations, to see how high a hurdle there is for active management. And, 2013 isn't unusual in providing a wide dispersion of returns.

Let's take a look at 2012, a year when the annual S&P Active Versus Passive Scorecard Indices Versus Active scorecard (SPIVA) found that 63 percent of large cap funds underperformed. While Vanguard's 500 Index Fund (NYSEARCA:VOO) returned 15.8 percent, the five best performing stocks in the Index returned between 109 percent and 188 percent.

Pulte (NYSE:PHM)


Sprint Nextel (NYSE:S)


Whirlpool (NYSE:WHR)




Bank of America (NYSE:BAC)


In addition to the five stocks that returned over 100 percent, 12 stocks returned more than 75 percent, and the top 25 stocks all returned more than 60 percent. Thus, active managers had plenty of opportunity to outperform the Index by overweighting this group.

Active managers also had plenty of opportunity to outperform the Index by underweighting the biggest losers. The table below shows the performance of the five worst performers:

Apollo Group (NASDAQ:APOL)


Advanced Micro Devices (NYSE:AMD)


Best Buy


Hewlett- Packard (NYSE:HPQ)


J.C. Penney (NYSE:JCP)


In addition to the five stocks that lost at least 44 percent, a total of 12 stocks lost at least 30 percent, and 25 stocks lost at least 18 percent. Clearly there was plenty of dispersion for active managers to exploit, yet a large majority failed to do so, as they persistently do.

As further evidence, a Vanguard study found that for every year since 2008 (when correlations started to rise), more than half the stocks in the S&P 500 Index finished the year with a return of 10 percentage points more or less than the Index. Thus, portfolio managers had at least 250 stocks they could under or overweight to generate a large alpha. In other words, every year we see a wide dispersion in returns, providing active management with ample opportunity to add value. It's just that as a group active managers fail to exploit that opportunity, each and every year.

The next time you hear the expression, it's a stock picker's market remember that there's really no such thing. It doesn't exist. Smart investors know that at least when it comes to this issue, it's never different. As William Sharpe explained in his famous paper "The Arithmetic of Active Management,": "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.