“It’s a stockpickers market” is a cliché. And it’s sometimes true and sometimes not. For example, in 2013 and 2015, two-thirds of funds in Trustnet’s all companies database outperformed L&G’s UK index fund (to take one All-Share tracker at random). In 2014 and 2016, however, less than one-third did so; and last year over 40 per cent did so. 2013 and 2015 were stockpickers' markets, then, but 2014, 2016 and 2017 were not.
What explains such big swings in the number of funds beating the index? To see it, imagine you picked stocks at random. You might think this would give you a 50-50 chance of beating the market.
Not necessarily. Indices weight shares by their market capitalisation: HSBC’s market cap of £157.6bn gives it 31 times the weight of Marks and Spencer, for example. This means that if big stocks do better than small ones, only a few shares will beat the market. Most random stockpickers will therefore underperform the index. On the other hand, if small stocks do better than big ones, most shares will beat the index and so will most random stockpickers.
And this is just what’s happened. In 2013 and 2015 the FTSE small-cap index beat the FTSE 100 and most active managers beat the market. In 2014 and 2016 the FTSE 100 outperformed small-caps and most active managers underperformed the market.
This isn’t to say that fund managers really are just picking stocks at random as they would if they had no skill. What it does mean is that sometimes stockpickers are swimming with the tide, and sometimes they are swimming into it.
If we want to know whether 2018 will be a stockpicker’s market, therefore, we need to know whether the FTSE 100 will beat small-caps or not.
Here, we have some luck. History tells us there is some predictability here. A handful of factors have in the past predicted annual returns on the FTSE 100 relative to small-caps.
The FTSE 100 has tended to beat small-caps in the 12 months after the dividend yield on the FTSE 100 has been high, which shouldn’t be surprising. It's also done well after interest rates have been high; not just three-month rates but also five-year yields and longer-dated index-linked yields. It shouldn’t be surprising that big stocks are more resilient than small ones to tight monetary conditions. What might be surprising is that this doesn’t seem to be priced into stocks immediately.
Small-caps, however, have outperformed in the 12 months after yields on the All-Share, FTSE 250 or FTSE 350 low-yield index have been high. Such high yields are a sign that investor sentiment is unusually depressed. As it recovers, small-caps outperform the FTSE 100 as they are more sensitive to changes in sentiment.
As you’d expect, these factors don’t give us perfect predictability. They explain only three-fifths of the variation in relative returns on the two indices. In particular, the FTSE 100 did better last year than they predict – perhaps because global markets and the global economy did well and the FTSE 100 is more closely tied to these.
Right now, these factors point to the FTSE 100 underperforming small-caps over the next 12 months, which suggests it should be a good year for stockpickers.
There are, though, caveats to this. If sterling falls the FTSE 100 could do well to the extent that the sterling value of overseas earnings rises. The 100 should also do well if global markets and the world economy continue to thrive. Personally, though, I doubt whether both are likely.
This year might well, therefore, be a good one for stockpickers on average. You can believe this even if stockpickers lack any genuine ability. It’s simply because they’ll have the tide in their favour. But, of course, the tide will turn eventually.
