Narrow markets should humble macro forecasters

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The writer is a former global head of asset allocation at a fund manager

This year has been marked by strong equity markets, and what looks to be an astonishingly narrow rally. Of the 16.9 per cent returned by the S&P 500 index in the first half of this year, 12.9 per cent derived from the performance of only 10 companies.

With such a high proportion of a market’s value created by so few groups, it feels fair to question the tool kits of asset allocators and, more broadly, the product line-up of fund management firms.

Narrow stock market returns are, after all, the norm. Research by Arizona State University professor Hendrik Bessembinder shows that more than half of the $55.1tn in net wealth generated by the US equity market between 1926 and 2022 came from the performance of fewer than 0.3 per cent of the market’s stocks, with the other half of this net wealth coming from the next best 3.1 per cent of stocks.

Moreover, almost three-fifths of stocks actually destroyed wealth over the period. In quant-speak, the distribution of compound stock returns has been very positively skewed.

In addition, the skewness of equity returns turns out not to be a particularly North American phenomenon. Indeed, in the three decades ending in December 2020 the proportion of net wealth contributed by the best 1 per cent of emerging market stocks was more than 80 per cent.

Looking at the entire global stock universe outside the US, the proportion rises still further to more than 90 per cent. Winners have won big. Most individual stocks over the past 30 years have failed to outperform dollars stored under the mattress, let alone a local currency interest-bearing cash deposits — even after taking into account dividends.

Bessembinder’s work has typically been surveyed in terms of what it means for active stockpickers — with some seeing it as a rationalisation for chasing moonshots and others for pursuing passive index-investing. Less examined has been what it means for asset allocators.

Developed market stock index returns have been dominated by global companies — even if they each carry a domestic tilt. As such, connecting local macroeconomic developments to the performance of a region’s equity index can be something of a dark art.

Single large stocks with an economic fate that has little to do with their listing jurisdiction have dominated national index returns. For example, the photolithography machine-maker ASML accounts for more than a fifth of the total net wealth created by Dutch stocks in the 30 years up to 2020. Global fast-fashion retailer Inditex accounts for more than a sixth of Spanish stock returns. Global luxury brands LVMH and L’Oréal collectively account for almost a quarter of the returns from French stocks. These are not outliers. One cannot explain long-term returns without reference to such companies in pretty much any region.

If it becomes hard to explain equity index returns without reference to specific superstar groups, it stands to reason that it must be even harder to forecast equity index returns without taking a view on some individual companies. It’s easy today to focus on whether the Magnificent Seven that have powered the S&P 500 rally — Apple, Microsoft, Google owner Alphabet, Amazon, Nvidia, Tesla and Meta — might stumble. With more than a quarter of the US market’s valuation riding on them, the question is not at all trivial. But 30 years ago, five of these seven had not even listed. It’s hard to take a view on companies that don’t yet exist.

I’ve been as guilty as the next asset allocator in explaining my preference for US over European stocks or vice versa with reference to some domestic macroeconomic outlook. Given that financials, utilities and property groups will carry a strong domestic flavour, this is still forgivable.

But when constructing a long-term strategic asset allocation, it is becoming increasingly untenable to justify regional preferences with reference to local macroeconomic forecasts. This may explain why long-term return forecasts for equity markets — or Capital Market Assumptions, as they are known — have such a lousy record.

The biggest single investment decision any institutional or individual investor is likely to make in their portfolio is their choice of strategic asset allocation. To create a strategic asset allocation one must make reasonable guesses about future market returns. Bessembinder’s research shows quite how invariably such reasonable guesses will be blindsided by the fate of single stocks.