What do markets react to?
While discussing his views on the corporate profit cycle in the US with CNBC’s Michael Santoli, Richard Bernstein provided an interesting insight: The Market does not react to the absolutes of good or bad—it’s always better or worse. Let’s see what he means.
Absolute versus relative
If someone told you that XYZ Corporation’s profits rose by 15% quarter-over-quarter, would you be pleased or disappointed? The correct answer is neither. Until and unless you get more information on profits, either reaction would be unjustified.
Consider this—if the company had consistently posted an average profit growth of 20%, a 15% rise would be disappointing despite the positive appearance in absolute terms. Also, if the industry that the stock belongs to has been on a tear and the peer group that the company belongs to has posted an average growth of 30%, growth of 15% would be a flashing red warning sign. On the other hand, in a dismal scenario, profit growth of 15% would be deemed an excellent indicator.
This demonstrates that one’s reaction should be based on the relative performance of a stock or instrument rather than on absolutes. As far as funds are concerned, the same concept applies in terms of returns—an absolute return means little if the risk-adjusted performance of a fund is poor.
What’s the point?
The point that Bernstein was trying to drive home was that a year-and-a-half or so ago, a lot of investors were reading profit signs as positive—without considering their relative meaning. While they were looking at the absolute performance of a company and were reading it as a positive sign, the relative performance was actually getting worse.
One reason why some professional managers seem to do better than some of their peers is that they’re aware of these and other investing traps while picking stocks for their portfolio. However, judging whether your fund manager is skilled or just lucky is difficult.
This is one reason why some investors choose passive funds such as the SPDR S&P Dividend ETF (SDY), the Vanguard High Dividend Yield ETF (VYM), and the iShares S&P 500 Growth ETF (IVW). Investors may also choose to have some exposure to actively managed mutual funds (DUGAX) (KLCAX).
In light of his assessment of the stages of the corporate profit cycle, Bernstein noted that his firm has become more cyclical in the past quarter or so to take advantage of the gradual improvement in profitability. In the next article, we’ll explore the basics of cyclical investing.