Finding Value In A Sideways Market

A Trendless Market - Now What?
The previous two scenarios showed trends that were easily identifiable. However, when the market is not showing any trend - either it's sideways or it's volatile with huge swings up and down in a short time period, investing becomes much more onerous and disproportionately less predictable.

Figure 3

Source: Bloomberg

As depicted in Figure 3, between September 2006 and June 2008, the S&P 500 had a total return of 10.5% and an annualized return of 5.9% with 13 positive months and eight negative months. Similarly, between March 2004 and October 2005, as depicted in Figure 4, the S&P 500 had a total return of 7.5% and an annualized return of 4.4% with 12 positive months and eight negative months. During these time periods, different macro trends characterized the market, but similarities do exist with sectors that tend to outperform or underperform during trendless markets.

Figure 4

Source: Bloomberg

Dividends Pay
There are industry groups that tend to outperform in trendless markets and those that tend to underperform given the nature of their businesses. Think of the things in life that are necessary and compare them to those that are luxuries. Healthcare services, healthcare facilities, utilities - to name of few - tend to be steady, slow growers; they rarely have a surprise hiccup and are able to pay dividends. Companies that pay dividends tend to hold up well in directionless markets, given there are no negative fundamental or macro trends, because investors get paid while waiting for the market to settle out.

Industries and companies that are subject to earnings surprises tend to be extremely volatile during trendless markets - investors are cautious and timid and tend not to grant any leeway or give any benefit of the doubt. Thus you can see some extreme volatility during these times. Conversely, many stocks tend to trade within a range as investors fail to see trends and put additional money to work. Because there are very few indications that point investors in one direction or another, it is more important to understand macro themes and fundamentals to find undervalued investments than try to find sectors that may fare better or worse.

Out of Trend … What to do?
Trendless markets generally require investors to become intimately involved with macro themes - to understand what is driving the global economy and what will persist in the long term. They must also look at company fundamentals, especially the drivers of growth. With non-directional markets, timing becomes much more important, but historically, it is a very difficult concept to execute. Short-run profits are difficult in trendless markets, but finding companies that are undervalued with growth drivers that will continue to spur global or local economic growth should produce profits in the long run.

For example, the time period depicted in Figure 3 was characterized by a strong global infrastructure build, especially in China and India, necessitating a greater supply of materials and energy to meet the increased level of demand. As a result, agriculture and chemicals also experienced higher demand. Thus, the best performing industry groups were fertilized and agricultural chemicals (+164%) and diversified metals and mining (+130%). In addition, various energy industries comprised three of the top 10 best performing industries.

Knowing the macro trends driving global growth and anticipating whether these trends will continue in the future is the most important aspect to choosing investments in this environment. Getting these investments at a discount is the key to returning profits to the investor.