First Eagle Investment Management – Market Narrowing: A Cue For Active Management
Headlines proclaimed the sharp decline in global stock markets that commenced in January 2016, but in fact the downturn had begun long before the headlines appeared. While the S&P 500 Index finished 2015 with a modest increase, the market’s performance was far from uniform. The 1.38% total return of the index can be broken into two components: a 3.3% positive return from the top 10 contributors and a 1.93% negative return from all the other stocks in the index. In other words, the top 10 contributors accounted for 240% of the total market return of the S&P 500 Index in 2015—far and away the largest percentage the top-10 stocks have contributed since the Global Credit Crisis (Exhibit 1).
The distortion presented in Exhibit 2 (next page) tells the same story from a different angle. By the end of 2015, roughly 30% of stocks in the S&P 500 Index were trading above their 200-day moving average. In other words, the great majority of stocks were losing ground.
First Eagle Investment Management – Market Narrowing
Why did the market narrow so dramatically? In 2015, as in the two prior years, we believe investors’ relentless pursuit of growth stocks and impatience with value stocks were the key drivers. As corporate growth became quite scarce, a small group of stocks scored strong gains while most other stocks in the index languished.
In our view, the narrowing that occurred in 2015 should have sounded an alarm for investors in passive funds—particularly those tracking capitalization-weighted indices. As a few stocks climbed to astronomical heights, passive funds were generally obliged to buy them at higher and higher prices. An investor who overpays for a security faces the very serious risk of permanent impairment of capital.
Market narrowing may indicate risky conditions for passive investors. The trend that appeared in 2015 may have reminded some investors of the “Nifty 50” stocks that predominated in the 1970s. The Nifty 50 were large-cap US growth stocks that were considered solid buy-and-hold investments by a large number of investment managers. Their prices were driven higher and higher, and when the market crashed in 1973, the overvalued Nifty 50 suffered a steep decline.
For active managers who focus on fundamental stock selection and seek downside protection, last year’s market narrowing had a very different impact. For First Eagle, it was a source of opportunity. We seek to purchase shares that are trading at a discount to our estimate of their intrinsic value, and when the market neglected the great majority of stocks, some fell to price levels that interested us. In 2015 we were able to buy shares of companies that had been on our wish list for some time.
We endeavor, above all, to protect our clients’ purchasing power. Aware of the underlying frailties in the markets, we focus on building an all-weather portfolio that can potentially take advantage of declining—or narrowing—markets, as well as rising ones. We believe our form of active, benchmark-agnostic value investing may help meet the challenges of all stages of the market cycle.