The economic concept of ZERO SUM is lately particularly applicable to the stock market. Traditionally, the stock market reflects business conditions of the economy. This implies the notion that a strong economy will move the overall market higher. ZERO SUM betrays this conventional wisdom that stock prices will follow the economy. ZERO SUM holds that for every stock market winner, there will be a loser.
During 2005, the economy expanded at a robust rate. The fourth quarter of 2005 marked 12 consecutive quarters of growth for the US economy. Total gross domestic product growth should exceed 4% in 2005. This suggests that the stock market should have had a strong year in 2005. Yet the major market indexes were barely positive for the year. The S&P finished up 4.98% and the DOW closed up 1.72% for the full year 2005. Why didn’t the stock market perform better when accompanied by such a robust economy?
Looking further back, theS&P 500 is up only 1.5% per year since the third quarter of 2001 when 911 shook the world. This basically sends the message that the stock market as a whole is stuck in a trading range. If the last four years are a guide to the future, why would we invest in the stock market if the return on the major averages has been so low?
The principle of ZERO SUM provides the answer. Despite the DOW breaking 11,000 for the first time since 2001, the DOW first reached that milestone in early 1999. For six years the DOW 30 stocks have had zero appreciation. Many stocks have done far better. The Russell 2000 and the S&P Midcap, for example, are making all time highs, even above their heady year 2000 levels. These indexes hold different companies than the DOW and the S&P. They have 4 year returns better than 12% per year. The conclusion is that large companies that hold the highest market capitalization have been stagnant. Meanwhile, smaller companies have appreciated handsomely.
This is why ZERO SUM is an applicable investment principle. It holds that for every rising stock price, there will be a falling stock price. For every disruptive growth stock like Google, there will be an example of a corporate disaster.
There is a bright side to ZERO SUM. Corporate giants with lagging stock prices like General Motors, General Electric, Pfizer, WalMart, Intel, et. al., mask the strength in less recognized companies. This landscape provides investors with a wonderful opportunity. For the next several quarters, investors will grow impatient with holdings in slow-growth companies and they will shift money into companies which show promise of higher growth. ZERO SUM should be the guiding light for portfolio management during 2006. For every advancing stock, there will be a declining one. This will keep the DOW and the S&P close to current levels while offering some fantastic gains in the more dynamic companies.
These investment opportunities should be further buttressed by the wave of merger and acquisitions which is taking place at an accelerated rate. Foreigners are buying market share by acquiring US companies. Domestic companies are finding that the most efficient way to achieve growth is through acquisition. This should further spur the takeover trend.
Peregrine clients in our Equity Composite had an average 2005 return of 16.19%. Our clients in our Balance Composite had an average return of 5.95%. These returns were above the industry’s standard benchmarks.
Generally, investment managers had a fine year in 2005. The average mutual fund was up 6% and many sector funds had gains above 10%. In the past, investment managers always struggled to match the return on the S&P 500. In the past two years, mutual funds have handily beaten the broad market. Indexing an investment portfolio is probably a passé strategy.
Carol, Grant, and I are committed to finding these opportunities to achieve growth for our client’s portfolios.
Past performance is no guarantee of future results. Investment management involves the possibility of losses. Significant general stock market moves up and down can influence the performance of client portfolios. Composite returns are based on client portfolios of over $100,000. Not all clients are included in the composites. All returns include the reinvestment of dividends. All returns are net of fees. Composite returns are derived from aggregated, time-weighted returns for clients of Peregrine Asset Advisers. Individual client returns can deviate from the composite returns. While Peregrine uses the S&P 500 as a benchmark, Peregrine does not attempt to mimic the structure of this index. Individual client portfolios vary. The number of securities held also varies per client.
Do you have questions or would you like to know more, contact Dan Botti.