Many stock markets might be sitting at close to record highs but the prospect of any significant growth in the near term seems limited, leaving investors with the question of how to deal with a sideways market. 
The FTSE 100 is current trading around the 7,400 mark – not far off its record of just under 7,600. Global indices such as the MSCI AC World and those in US like the Dow Jones, S&P 500, Nasdaq are also close to their highest ever levels.
But commentators such as Paras Anand, chief investment officer for equities, Europe at Fidelity International, suggest that stock markets could be stuck in a trading range with limited prospects for equity prices to push much higher at an index level.
“There has been one particularly interesting stock market scenario to consider over the past year or so,” he said.
“The global economy could continue to surprise on the upside but the impact on the medium-term path of equity prices would be weaker. In short, there is a prospect of a period of consolidating or sideways markets. Indeed, the world may have already entered such a climate.”
Performance of indices over 10yrs
Source: FE Analytics
Indeed, Anand argued that there are a number of reasons why equity prices could struggle to go much higher, even against a broadly optimistic view of the global economy – the IMF today said it expects expansion of 3.5 per cent globally, even though it downgraded the UK and the US – and the prospect for corporate earnings growth.
Firstly, a significant part of equity markets’ return in the years since the financial crisis has come through multiple expansion, which means that, at the aggregate level, markets offer less value today than they did a few years ago.
Meanwhile, the returns of well-established companies and industries are under pressure from price competition and share erosion from technology-enabled business models, which the CIO said does not “feel” like the conditions of broad bull market.
Finally, real wage growth has been sluggish despite most developed economies demonstrating strong employment trends.
When examining how investors should act in a sideways market, Anand considered the work of Legg Mason Capital chief investment strategist Robert Hagstrom, who is arguably best known as a Warren Buffett analytical biographer and wrote a paper on sideways markets in 2010.
Anand said that the central point of Hagstrom’s paper – which examined the characteristics of the sideways market that the US experienced during 1975-1982 – was the number of individual stocks that posted genuinely outsized returns in these conditions. The research highlighted stocks that made 100 per cent or more over different time frames and identified the factors that were most and least profitable for investors during the period.
“The research offered some interesting conclusions – first that the opportunity for exceptional gains in individual stocks was not diminished by the lack of broad market direction. In any given single year, only a small percentage (3 per cent or 16/500) stocks posted returns of 100 per cent or more,” the Fidelity CIO said.
“However, as the time periods extend (looking at the number of stocks that posted returns of 100 per cent or more over three and five years) to more accurately reflect the holding periods of institutional investors, a surprisingly high percentage of shares posted outsized returns: 18.6 per cent for three years and 38 per cent (190 out of 500 stocks) over five years. In other words, the average simply mattered less.”
Another interesting point of the research was that valuation (as opposed to value) and the quality of a company’s earnings were the most ‘profitable’ strategies during the sideways market while investing on the back of momentum, or short-term market reaction, was the least.
Key sideways markets
Source: Fidelity International
Of course, Hagstrom’s paper only looked at a single period in stock market history so Anand replicated the research across other markets which have shown the same sideways tracking characteristics. Using an algorithm to identify markets that over three years or more have experienced unusually low absolute-price returns, he highlighted the S&P 500, FTSE All Share, MSCI AC Asia ex Japan and the Topix – as shown above.
Anand tweaked the definition of ‘outsized returns’ from a return threshold of 100 per cent in Hagstrom’s research to 75 per cent in his own. This was to reflect the fact that inflation has been significantly lower in the periods he examined (in the S&P 500’s 1975-1982 sideways market, inflation was in double digits).
“Interestingly, the number of stocks making outsized returns in these sideways markets is comparable to the US in 1975-82,” he said.
“This showed that, once again, tepid broad market performance does not prevent many individual stocks from posting strong returns. Over one year, between 2.8 per cent (FTSE All Share) and 5.1 per cent (Topix) of stocks achieved outsize returns, but this rose to between 10.8 per cent (MSCI Asia ex Japan) and 29.4 per cent for the FTSE All Share over the three-year period.”
Anand also replicated the original research’s analysis of which strategies work best in a sideways market and considered three style factors: valuation, earnings quality (growth), and momentum.
The table below shows the performance of these strategies during each sideways market in each index. As can be seen, top performer in these markets was always either the valuation or earnings quality strategy while momentum performed worst in all but one market.
Relative performance of valuation, earnings quality (growth) and momentum strategies in sideways markets
Source: Fidelity International
“What can we conclude? Markets will drift sideways at times and there are reasons to think that broad equity indices might be range-bound,” the CIO said.
“However, with a strategic focus on identifying companies offering attractive valuation with a high underlying quality of earnings, outsized returns from individual shares are accessible. In short, a sideways market is nothing to be afraid of.”