Oscillations In Opportunity

2020 was a year of two reversals for the market. First, equities recovered from the depths of March to finish the year strongly, and second, smaller-cap and value stocks staged a roaring comeback in the final quarter.

We can better understand the second reversal by analyzing the market’s distribution of returns and the performance of stocks relative to the index as a whole. Exhibit 1 illustrates this for the S&P 500® for the past 20 years. Of the 980 stocks that were in the index during this period, only 211, or 22%, outperformed. When only 22% of the stocks beat the market, stock picking is hard, underscoring the persistent underperformance of most active managers.

Exhibit 1 summarized 20 years of data, but we also see the challenges of stock selection in most individual years, and 2020 was no exception. Exhibit 2 shows that the S&P 500’s return for 2020 (18.4%) was much higher than the median stock’s return of 8%. The outperformance of large-cap stocks meant that only 34% of stocks beat the index.

However, the path for stock-pickers was not a straight one in 2020. Exhibit 3 shows that from Q1 through Q3, the S&P 500 posted a return of 5.6%, as mega-caps outperformed during the period. As a result, only 35% of stocks were able to outperform the index.

In contrast, in Q4, the market reversed course, where the S&P 500’s return of 12.2% was much below the median of 17.1%, signaling the recovery of smaller-cap stocks. Therefore, 60% of stocks were able to outperform the index, almost double what we saw in the first three quarters.

This analysis has interesting implications for active management: The dominance of mega-caps hindered stock selection from Q1 through Q3. Meanwhile, in Q4, the comeback of smaller caps lowered the threshold for success, leading to a greater hit rate of outperforming the index. It is not solely the distribution of returns, but the return distribution across the cap range that matters.

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