Failing To Consider Market First Is Detrimental To Your Portfolio's Health

by: Joseph Meth


Self-directed investors should invest more time in gauging the health and trend of the market than finding winning stocks because:

70% of all stocks saw their prices appreciate during 2013.

Only 126 stocks, or 5.5%, saw their price appreciate during the final 12 months of the Financial Crises Crash.

In a recent SeekingAlpha article (Top Down Vs. Bottom Up - Which Investor Has The Edge? by David Nelson, the Chief Strategist of Belpointe Asset Management) argued that selecting stocks through screens of fundamental criteria was sufficient and, actually, delivered superior results to a more technically-based, trend-following approach. Nelson summarized two alternative portfolio management processes which I paraphrase in the following schematics:

Bottom Up - Investors using this approach might have the same views of the economy as top down investors but they make stock selections first and foremost by running thousands of corporate financial statements through quantitative screens of criteria like value, positive estimate revisions, product cycles, and pricing power.

Top Down - These investor start off looking at the world by focusing first on broad economic themes and then drilling down to sectors and then individual stocks that meet certain criteria. If the economic backdrop isn't attractive they stay out of the market or, at the very least, under invest by holding large amounts of cash.

Nelson argues that a majority of those following the top-down approach are "avoiding the market because stop signs are everywhere." His "5 most popular reasons to avoid the market."

  • "Stocks have come too far too fast."
  • There's a "a disconnect between market fundamentals and stock prices."
  • "Margins are unsustainably high and will soon revert to the mean crushing profits"
  • "China is often mentioned as a negative catalyst."
  • "Rising tensions in the Middle East, South China Seas and the Ukraine are the biggest risks investors face."

Alternatively, he claims that the Bottom Up approach (my emphasis added):

  • "Tends to keep me in the game longer."
  • "There are "stocks and sectors that can do relatively well even bear markets."
  • "Rank thousands of stocks based on factors I believe are important in the investment process."
  • "The debate usually centers on just how much you are willing to pay for {a given growth rate}."
  • "It does some of the timing for you because some sectors or industries are left underweight simply because too few stocks meet the criteria".

I believe individual investors, however, are better served if they elect Top-Down. Most of us, regardless of how hard they might try, don't have the tools or skills needed to outperform broad market benchmarks by any meaningful degree. As a matter of fact, statistics show that professional managers have also consistently failed to do so. Self-directed investors with diversified portfolios of 20 or more stocks should invest their time and effort in evaluating one stock proxy ... the market. They should spend less time in searching for the next winner than:

  • Avoiding the purchase and retention of obvious poor performing stocks; and
  • Protecting the portfolio's value during bear markets and crashes when;
  • Macroeconomic conditions trump the fundamentals of nearly all stocks no matter how strong.

If you created a portfolio of 20-30 stocks at random from among the Russell 3000 stocks, that portfolio's average annual price change would be close to that of the Index itself (the same would be true for the 500 stocks comprising the S&P Index).

The following charts compare both the individual and cumulative distribution of changes for all the Russell 3000 stocks in two dramatically different periods: the 12-months ending 12/31/13 (blue line), and 12 months ending 3/9/08 (red line). [The statistics were actually based on 2870 stocks since 130 were added to the Index during the latest 12 months period] (click on images to enlarge):

On the other hand, it would have been difficult putting together a portfolio at the beginning of January 2013 that wound up twelve months later with a loss:

  • Fully 349, or 12%, of the list had gains of 50% or more over the twelve months.
  • Another 70%, or 1991, saw their prices appreciate over the year with: 29%, or 676, gained 30-50%; 71%, or 1315, gaining 0-30%; Only 30%, or 879, ended the year with a loss (these are the stocks we work hard to avoid or sell before the losses accumulate).

The odds are that it would have been difficult to lose money in 2013 regardless of how inexperienced or novice you were. However, had you the time to research all 3000 stocks, the odds are that the Bottom Up approach would not have been able to find many of the rare stocks that appreciated 50% or more (and perhaps wasn't really a need to find them because there were so many others stocks that performed well).

But here is where the Bottom Up argument really breaks down. If you had used that approach to select stocks twelve months before the Financial Crises Crash bottomed on 3/9/09, no matter how experienced and skilled you may have been, you probably would have been unable to assemble a portfolio that would have insulated you from a loss. It's Bear Markets and Crashes, not Bull Markets, that separate the amateurs from the pros:

  • Only 126, or 5.5% of the 2284 Russell 3000 stocks in 2009 for which data is available today, increased in price up in the twelve months ending March 9 2009.
  • Of the 94.5% that lost value during those twelve months: 43.4% lost 0-50% of their value, while 56.6% lost more than 50% in value.

In other words, the odds of picking a horse at the racetrack is better than picking a stock that will appreciate during a bear market or when the market is crashing (which comes about once every 7 years).

Regardless of whether you use fundamental or technical analysis to select specific stocks for your portfolio, your search should always first begin with an assessment of the market's health and likely future trend. In other words, the Top Down approach is the less risky and most likely to produce the best long-term results.

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