Strength begets strength

.

  By Guest Blogger Doug Rowat

.

The Edmonton Oilers are on a roll.

With their current winning streak at 16 straight games, records are falling by the day. Most consecutive wins in franchise history, which is saying something given the Oilers’ Gretzky-led history. Longest franchise goalie winning streak with netminder Stuart Skinner surpassing Oilers legend Grant Fuhr. Longest winning streak in Canadian-team history.

We’ll have to wait until after the All-Star break to see if they can tie (and perhaps best) the all-time NHL record of 17 consecutive wins, but regardless, their winning streak has become a cause for celebration in oil country.

However, when the stock market sets records, it’s often not so much a cause for celebration as a cause for anxiety. Investors get jittery and the impulse to sell into strength becomes strong.

The S&P 500 hit another record high on January 19 and, as of this writing, has tacked on another six record closes this year. But, as is often the case, many investors now worry that the rally is unsustainable, and the market overbought. In other words, many investors are itching to hit the sell button.

However, the S&P 500 being at a ‘record high’, in and of itself, provides zero evidence that the rally will end. First, record highs for the S&P 500 occur constantly. Invesco, for example, highlights that the S&P 500 has hit 1,176 new highs since its 1957 inception (the official date of it becoming the ‘500’ index):

[It’s] the equivalent of a new high every fortnight, or 14.3 days. History suggests that investors should expect the market to ascend to many new highs over their lifetimes, even if the path isn’t always a straight one.

So, a new record high about every two weeks. Historically speaking then, record highs aren’t to be feared but rather EXPECTED.

And why? Because positive market momentum usually persists. Ned Davis Research, for instance, points out that the median gain for the S&P 500 in a year where it sets a record high is more than 15%. And once the S&P 500 notches its first record high, many more usually follow, which, of course, increases the median annual gain:

S&P 500 ‘record highs’ usually come in bunches

Source: Ned Davis Research

But what if markets get choppy? No doubt something will emerge in this year’s news-cycle that will cause volatility to spike. Conventional wisdom suggests that once volatility becomes elevated, setting new highs becomes more difficult, if not impossible. However, as Societe Generale points out, this is not the case. Naturally, nose-bleed volatility isn’t good for markets, but moderate-to-high volatility is fine. As the below chart shows, S&P 500 records aren’t set only when volatility is low:

CBOE Volatility Index (VIX) vs S&P 500 highs (circles): Higher volatility is uncomfortable, but it doesn’t limit the S&P 500’s ascent

Source: Societe Generale

So don’t get anxious when the S&P 500 sets a new record. Be like an Oilers fan and enjoy the ride.

$     $     $

Finally, Archer-Daniels-Midland (ADM) is the worst performing stock in the S&P 500 this year, which is saying something given that it’s up against ‘loose bolts’ Boeing.

Placing your CFO on administrative leave, cutting growth forecasts and delaying the release of quarterly results doesn’t usually inspire investor confidence and indeed ADM stock is now down 24% y-t-d. Whether ADM ends up recording a “catastrophic loss”, which JP Morgan defines as a 70% share-price decline with minimal recovery, remains to be seen, but ADM’s share-price collapse this year highlights the danger of individual stock picking, particularly when juxtaposed against the broader S&P 500, which, as highlighted above, continues to set records.

JP Morgan routinely examines the universe of Russell 3000 stocks and has found that more than 40% of them at some point suffer catastrophic losses. JP Morgan has tracked Russell 3000 stock performance since 1980 and its most recent report shows that the odds of a catastrophic loss have, in fact, become higher since its 2014 report:

The odds of any given stock blowing up were always high, but the odds have worsened

Source: JP Morgan, Turner Investments. Based on Russell 3000 Index data. A catastrophic loss is a permanent decline of 70% or more.

It’s a lesson in concentration risk. Imagine holding a concentrated portfolio of, say, 10 stocks and three or four of them experience a catastrophic loss? Such an outcome would likely completely derail an investor’s finances.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.