Normal markets

Given the market’s dramatic slump, however, the performance of individual stocks has been much less unusual. In fact, my no-thought benchmark portfolios have done pretty much as you might expect given the market’s performance.

This is most obviously true of high-beta stocks. My portfolio of them lost 43.6 per cent in the quarter, with huge losses on stocks as otherwise different as Asos (ASC), Cairn Energy (CNE), IWG (IWG), Melrose Industries (MRO) and Premier Oil (PMO).

By contrast, my low-beta portfolio outperformed the FTSE 350, as gains on Plus 500 (PLUS) and Polymetal (POLY) offset big losses on Dart (DTG) and Marston's (MARS).

Granted, the outperformance was small, in part because when investors panic they sell whatever they can and lower-beta stocks tend to be liquid. This reminds us of an important fact. All companies, however safe or well-managed they might seem to be, carry lots of market risk and so are likely to fall when the market plunges.

This is not to say that the textbook capital asset pricing model (CAPM) is right. It’s not. It predicts that high-beta stocks should outperform a rising market and low-beta ones should underperform. While this is true for short, sharp market rises, however, it is not true over the longer term. The FTSE 350 has risen in the past 10 years – albeit only slightly – and yet in this time high-beta stocks have halved in price while low-beta ones have actually performed well.

A big reason for this has been pointed out by economists at AQR Capital Management. They show that many investors cannot borrow as much as they’d like. When they are bullish, therefore, they don’t borrow to buy equities generally as the CAPM predicts. Instead, they gear up by buying higher-beta stocks. This causes these to be overpriced and low-beta stocks to be underpriced. And because investors are bullish most of the time (because in theory shares should outperform safe assets on average) so high-beta stocks are overpriced most of the time. The upshot is that they underperform on average. In this sense, the long-run poor performance of my high-beta portfolio is consistent with that of high-beta assets in other markets.

Another portfolio that has performed as expected (conditional upon the market’s slump) is our value portfolio, which comprises the 20 highest yielding shares on New Year’s Day. It has fallen further than the market, with big losses on stocks such as Hammerson (HMSO), Tullow Oil (TLW) and Crest Nicholson (CRST) outweighing rises in Hastings (HSTG) and Plus 500.

This just reminds us of an old fact: that very high yields are often a sign of high risk, usually cyclical risk. In 2007, mortgage lenders and housebuilders were on big yields, but they got clobbered by the financial crisis. In the same way, the likelihood that we are now in a deep recession is hitting value stocks hard.

Investors who thought that a big fat yield would give them some protection have been wrong.

There is a silver lining here. When investors start to anticipate the economy bouncing back, value stocks should do especially well. Betting on this now, however, is risky as such stocks would be hard hit if investors are disappointed by any delay in the upturn. Any good returns on value stocks would only be a reward for taking this risk.

Our momentum portfolio – comprising the biggest risers in 2019 – also had a bad first quarter, losing even more than the market thanks to big losses on Dart, IWG (IWG) and Rank (RNK). This is consistent with a theory proposed by Victoria Dobrynskaya at Moscow’s National Research University. Momentum stocks, she says, have nasty betas: they do especially badly when the general market falls. For example, they also underperformed when the market fell sharply in late 2018.

On average, though, investors are well-rewarded for taking on this risk. Over the past 10 years, our momentum portfolio has risen by an average of 5.9 per cent per year, while the FTSE 350 has risen only 0.6 per cent. I suspect, therefore, that investors have been more than compensated for taking on beta risk over the long run. Which suggests that something else also explains momentum’s good long-run performance. This is that investors underreact to both good and bad news, which means that shares that rise are nevertheless still underpriced while shares that fall are overpriced even at low levels.

This seems to have been the case with our negative momentum portfolio. It lost a lot in Q1 thanks to big falls in Tullow Oil, Saga (SAGA), John Wood (WG.) and Centrica (CNA), among others.

In one sense, this isn’t surprising. Stocks that have fallen a lot are unusually risky, so investors dump them in bad times. What might be surprising, though, is that this portfolio has done terribly over the longer run.

One explanation for this is that investors often stick too strongly to their prior view that a stock was worth buying in the face of bad news. This means that when a share suffers such news it does not fall enough and stays overpriced, with the result that it drifts down later.

If this explanation is correct, we might expect negative momentum shares to do well if or when the market bounces back. One reason for this is simply that such stocks are unusually risky and so should recover when investors rediscover their appetite for risk. Another reason, though, is that it’s not clear that investors are now under-reacting to bad news about the worst hit stocks. It’s just as likely that they might even be overreacting.

Now, I don’t say any of this to recommend particular portfolios or strategies or to not recommend them. It’s entirely reasonable in these volatile times not to take strong market positions.

Instead, my point is that although the aggregate market has behaved abnormally – because these are abnormal times – individual stocks, for the most part, have not. Sure, markets are not wholly efficient. But nor have they been dysfunctional recently either.