Morningstar - Q4 2023 - 8

Dispatches
A Stock-Picker's Market
Investing success
requires humility.
PHILLIPS CURVE
Don Phillips
As it promises, Morningstar's fine new research
paper, " Explaining America's Stock Market
Dominance Since 2010, " elegantly explains the
recent dominance of U.S. stocks. (Spotlight,
Page 29.) What it doesn't do-indeed, what no
research ever does-is explain why so few
investors saw this now-evident trend coming.
We all know about the clarity of hindsight; it's
the future that's murky. That's why Morningstar
fund analysts chuckle when they hear fund
managers say that we're entering a stock-picker's
market. It's a refrain one hears from even the
brightest and most dutiful managers, but tellingly
it's a phrase only used to describe the future,
never the past. Yet, surely one could take the 20
best-performing stocks of any historical period
and assert that if you'd only been a gifted enough
stock-picker to have chosen those names, you
would have run circles around your competition
and trounced any index. In that sense, every
market is a stock-picker's market-rendering
the phrase meaningless. But managers never
invoke the phrase in retrospect, perhaps
recognizing the impossibility of having the luck or
skill to identify winners with such precision.
Instead, when managers assess past performance,
they see it through the now-developed picture
of the major trends that emerged during the
period. Armed with the knowledge of these trends,
it's easy to assert that past success was relatively
simple. For example, in explaining performance
over the years covered in the above-cited
report, a manager would likely claim that all one
had to do was to favor U.S. stocks and to have
overweighted technology. What could be simpler?
But the same manager when asked at the
beginning of the period would likely have said the
8
Morningstar Q4 2023
future would be a stock-picker's market. Likewise,
if you now ask the manager to forecast the
key to success in the coming decade, you'll likely
hear that it will be a stock-picker's market.
In essence, the phrase a stock-picker's market
is simply an admission that the trends that
will play out in the future are not yet clear to the
observer. And in that sense, it may be the
most honest thing anyone can say about future
market returns. But fund managers are paid
to be visionary and to have answers to questions
that befuddle the rest of us, thus making
the claim of a coming stock-picker's market an
essential face-saving tool for fund managers.
It also conveniently serves as a possible rationale
for hiring an active manager over an index
fund. That it carries no meaning for the listener
is beside the point; the phrase has utility for
the speaker.
Humility is not the characteristic most associated
with asset managers, yet it is an essential
component of being a successful investor. One
of the first investment books I read was The
Humble Approach, by John Templeton. In it, he
concedes that even with all of its expertise
and resources, his firm was going to be wrong on
close to half of its decisions. In essence, his
math came down to that of a baseball season.
Templeton recognized that if you win just 55% of
your bets, you will build great wealth and compile
an outstanding record, just as a baseball team
that plays .550 will likely make the playoffs
and have a shot at the World Series. Templeton
was emboldened by the realization that slightly
tilting the percentages in his favor offered
material benefits, even though he was humbled
by the recognition that he would still fail over
40% of the time.
Yet many investors act as though their insights
are infallible and that they can always get
it right. The evidence does not back their case.
Consider again the period cited in the Morningstar
report. Throughout this period, some of the
most renowned forecasters published estimates
of meager opportunities at best for U.S. largecap
stocks. If one wanted near double-digit equity
returns, then these experts suggested you
look at esoteric places like timber or emergingmarkets
value stocks. No firm that I recall
was making a pound-the-table case for U.S. stock
dominance in the wake of the financial crisis.
Rather, conventional wisdom of the time
called for broad diversification across geographies
and security types.
There was also a rush to explore alternative
assets and to seek better returns in areas
like private markets or cryptocurrencies. As a result,
many younger investors-many of whom,
sadly, were already saddled with crushing student
debt-turned their backs on equity markets
over this period. They missed what are now
seen as easy gains to have been won by simply
holding a U.S. market index fund.
Baby boomers have had the opposite experience.
Having enjoyed long success with stocks,
especially U.S. large caps, the past decade
reinforced their belief in the wisdom of
this exposure, likely inflating their hubris. Statistics
show that baby boomers now hold equity
positions far in excess of what traditional financial
planning standards would suggest are prudent
for their age. Their reluctance to move to
bonds given the ugly fixed-income returns of 2022
is understandable but probably unwise. Just
as the two stock bear markets of the early 2000s
set the stage for the superior performance
of U.S. equities since 2010, so too may the recent
difficulties of bonds make them a more rewarding
component of future portfolios.
Humility would suggest that the time to trim a hot
asset class is when all seems right with it,
as was the case with bonds in 2020 or U.S. stocks
today. But who's to say? After all, I have it on
good authority that the next decade is going to be
a stock-picker's market anyway. K
Don Phillips is a managing director at Morningstar. He is
a member of the editorial board of Morningstar magazine.
The views expressed here are not necessarily those
of Morningstar.
https://www.morningstar.com/lp/american-stock-market-performance https://www.morningstar.com/lp/american-stock-market-performance https://www.morningstar.com/authors/286/don-phillips
Morningstar - Q4 2023

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