The distinction between market risk and stock-specific uncertainty matters a lot for equity investors. This is one lesson of the performance of our no-thought benchmark portfolios in the last three months.
Viewed through a lower-frequency prism, the shock of Brexit did not cause an increase in market risk. In fact, the All-Share index rose in the second quarter - although this disguises a good rise in the FTSE 100 and falls in Aim, the FTSE 250 and smaller caps.
Instead, what we have seen is an increase in stock-specific uncertainty. This has manifested itself in two ways.
One is that there was a big rotation towards big, familiar stocks as the Brexit shock hit: our mega-cap portfolio has risen strongly since 23 June. The other is that defensive stocks did especially well: despite their low beta they beat the market in the quarter, thanks to a strong showing post-Brexit. The mirror image of this is that high-beta stocks did badly. All these moves are consistent with investors fleeing uncertainty and seeking security. This tells us that defensive stocks aren't just relatively low-risk assets, but low-uncertainty ones, too.
|Performance of no-thought portfolios|
|Q2 (%)||Last 12 months (%)||Last 3 years (%)||Last 5 years (%)|
|Price performance only: excludes dividends and dealing costs|
Brexit, though, triggered another rotation. Overseas earners such as miners benefited from the fall in sterling. This is why negative momentum did so well in the quarter; it had a strong bias towards miners as these had done badly in the previous 12 months. By the same token, positive momentum underperformed a little in the quarter because it was underweight in resource stocks.
On the other hand, though, big buyers of foreign currency-denominated goods suffered: these include retailers and big users of oil such as easyJet. Also, domestic cyclicals did badly for the same reason that sterling did - because investors anticipated slower economic growth.
These developments have been ambiguous for our value portfolio, which comprises the 20 highest dividend yielders. On the one hand, it benefited from rises in resource stocks such as BP, Glencore and BHP Billiton. But on the other hand, it was hit by falls in Berkeley and easyJet. Net, our portfolio of value stocks slightly underperformed.
All this is (thankfully) unusual. It's rare for markets to be hit by so clear an adverse growth shock to a domestic economy and fall in the exchange rate. What's much more common is for equities to largely shrug off moves in sterling as these are very often mere noise which is likely to be reversed. Because this cannot be said with confidence of the recent drop in the pound, it has had significant effects; it's likely that the weak pound is permanent, insofar as it reflects a genuinely worse economic outlook.
For this reason, I wouldn't draw very many inferences about equity strategy from the events of the last few weeks. Instead, we should look at the longer-term picture, which shows some clear trends.
One of these is that it generally pays to buy past winners and sell past losers. In the last three years our positive momentum portfolio has outperformed the negative momentum portfolio by over 60 percentage points. Exceptions to this occur if we get a sharp shock, such as the last quarter's drop in the pound.
Secondly, defensives tend to beat even rising markets. The counterpart to this is that higher-beta stocks tend to underperform them. This is due in part to many investors facing constraints on how much they can borrow. These mean that if they are bullish - which most are on average - they don't borrow to buy shares generally but instead increase gearing by buying high-beta shares. This means that these are, on average, overpriced and so subsequently fall. By the same reasoning, defensives are underpriced on average and so tend to rise. The exception to this general trend comes when shares rise very sharply, often because sentiment was so low initially. In such events, defensives tend to underperform.
Thirdly, deep value stocks - those on the highest yields - tend to be cyclical. This means they beat the market when the economy is expected to grow, but only to reward investors for the risk that they'll do very badly in the economy slumps. The good relative performance of our value portfolio in the last five years follows terrible falls in 2008, for example. In the last three months, we saw only a little bit of cyclical risk materialise: domestic cyclicals did badly but global cyclicals such as miners did well.
Fourthly, there seems to be no long-run tendency for mega-cap stocks to either outperform or underperform shares generally. This is consistent with Gibrat's law - the idea that growth is independent of initial size.
Yes, mega caps underperformed between 2011 and this year. But this was a period of decent economic growth that favoured smaller caps; in previous years, mega caps slightly outperformed. And the shock to growth and sentiment caused by Brexit triggered a rotation back towards mega caps.
These four trends should, I suspect, serve as a permanent guide to equity strategy. Of course, they don't operate all the time: in noisy data, nothing does. But they are reasonably robust guidelines for investing. Certainly, I prefer them to any strategies based on futurology and individual judgment.
There is, though, one other lesson here. Although the events of the last few weeks have been shocking (in both senses of the word!) such shocks haven't caused big underperformance of those equity strategies that have generally done well over the long term: momentum, defensives and (more arguably) value. This tells us something important. As long as the general market holds up well, reasonable diversification based upon established long-term principles can protect equity investors from losses. What equity investors have to fear is a fall in the general market. Everything else can be diversified away.
Our new no-thought portfolios
Momentum (the biggest risers in the last 12 months): Abcam, Acacia Mining, Admiral, British American Tobacco, Boohoo, Centamin, Cranswick, Dart, Darty, Domino's Pizza, Fevertree, Fresnillo, Hochschild, Intertek, JD Sports, NMC Health, Paysafe, Polymetal, Randgold, SABMiller.
Negative momentum (the biggest fallers in the last 12 months): Amec Foster Wheeler, Countrywide, Entertainment One, Essentra, International Personal Finance, ITV, Lonmin, M&B, Marks and Spencer, Melrose, Nostrum, Ocado, Pagegroup, RBS, Restaurant Group, Sports Direct, Stagecoach, Standard Chartered, TalkTalk, Thomas Cook.
Value (the highest dividend yielders): Aberdeen Asset Management, Amec Foster Wheeler, Berkeley, BP, Carillion, Debenhams, easyJet, Galliford Try, HSBC, Intu Properties, Legal & General, N Brown, P2P Global, Persimmon, Petrofac, Phoenix, Rio Tinto, Standard Life, TalkTalk, Vedanta.
High beta (The highest beta stocks in the last five years): 3i, Aberdeen Asset Management, Barclays, Bodycote, Centamin, Evraz, Glencore, Henderson, Hutchison China, Inchcape, Intermediate Capital, International Personal Finance, Jupiter, Mondi, Ocado, Pagegroup, Schroders, Thomas Cook, Travis Perkins, Vedanta.
Low risk (the lowest beta stocks): Acacia Mining, Breedon Aggregates, Cineworld, Consort Medical, De La Rue, Dechra, Dignity, EMIS, Euromoney, First Group, GVC, Imperial Innovations, James Fisher, Jardine Lloyd Thompson, National Grid, Nichols, Primary Health Properties, Tate & Lyle, Telecom Plus, Wm Morrisons.
Mega caps: AstraZeneca, British American Tobacco, BHP Billiton, BP, BT, Diageo, GlaxoSmithKline, HSBC, Imperial Brands, Lloyds Banking, National Grid, Prudential, Reckitt Benckiser, Relx, Rio Tinto, Royal Dutch, SABMiller, Shire, Unilever, Vodafone.
All portfolios are equal-weighted holdings of 20 stocks, drawn from those with a market capitalisation of over £500m.