Market Indices

Financial news typically portrays the stock market through the lens of market indices. There is an unlimited supply of such indices. However, a few of them are ubiquitous:

Index	Constituents	Representative ETFs
S&P 500 (SPX)	500 largest companies listed on U.S. stock exchanges	SPY, IVV, SPLG, VOO
Dow Jones Industrial Average (DJIA)	30 large companies selected to reflect the U.S. industrial sector	DIA
Nasdaq Composite (IXIC)	All stocks listed on the Nasdaq exchange	ONEQ
Russell-2000 (RUT)	2,000 smallest stocks in the Russell-3000 index	IWM, VTWO

All the indices above are cap-weighted, with larger companies having more weight than smaller companies. This scheme naturally aligns with the idea that the underlying stock baskets should not require rebalancing when stock prices fluctuate. However, this cap-weighting creates a new problem: A reduction in diversification, where a few mega-corporations account for large percentages of the total index. As an example, the S&P 500’s top-10 constituents sum up to more than 25% weight. Equal-weighted indices address this problem by applying the same weight to each company, regardless of its size or market capitalization. However, such indices are less commonly used, and require regular adjustments to maintain their equal weighting.

The S&P 500’s and Russell 3000’s inclusion rules are based on company fundamentals and relatively straightforward. As a result, these indices minimize inexplicable bias, making them good representatives of the overall stock market. Similarly, the Russell 2000 is a good representation of smaller cap stocks, as it is a natural subset of the Russell 3000 index.

However, not all indices are constructed in such a manner. Inclusion in the Nasdaq is based on a company’s trading venue. Because companies may, within limits, freely choose where they list their stock, the Nasdaq might have some unexpected bias and not be the tech-heavy index investors expect. Further, this bias will likely shift over time. As a result, investors seeking exposure to technology might find that better represented through a dedicated sector ETF.

Similarly, the inclusion in the Dow Jones index is determined by a committee, and not every investor might agree with their selection methods. Because the index only includes 30 stocks, it might additionally suffer from a lack of diversification. Again, investors seeking exposure to industrials might find that better represented through a dedicated sector ETF.

Large caps, small caps, industrials, and technology seem to be quite different in composition and nature, and it is natural to expect them to behave very differently. Interestingly, that is not the case. The equity chart reveals that, over the past 30 years, these major indices have led to remarkably similar results. The Nasdaq Composite shows the most notable exception, with vast outperformance in the 1990s, and a crash that took 15 years to recover thereafter.

The rolling returns illustrate this further. As the chart shows, the range of returns is typically very narrow, with the S&P 500 somewhere in the middle of the range. The most notable exception is, again, the dotcom boom and subsequent crash. This tight spread between these indices can be seen as both an advantage and disadvantage. On the positive side, investors won’t make a mistake with investing in either of these major indices. But on the flip side, there is also not much to gain by rotating between these indices.

By investing in these market indices, investors can reap sizeable returns. On a busy day, the stock easily moves by 1%. However, the table above shows that since 1990, we have observed many days exceeding this tenfold or even more.

Obviously, this is also true for the losses. What sticks out here is that the magnitude of these losses is remarkably similar to the maximum gains. Also, sizeable gains often go hand in hand with big losses, and today’s big winner might be tomorrow’s loser. Another detail worth noting here is that the tables are dominated by the Russell 2000 and the Nasdaq indices. This is an indication that small stocks and technology have higher volatility than the broader market or industrial companies, represented by the S&P 500, or the Dow Jones, respectively.

Capitalization	Growth	Value	Low-Volatility	Blended
Large Cap	SPYG, RPG, JKE, NULG, VOOG	SPYV, RPV, IVE, NULV, VOOV	LGLV, SPLV, VFMV	SPY, IVV, NULC, VV
Mid Cap	MDYG, RFG, IJK, NUMG, VOT	MDYV, RFV, IJJ, NUMV, VOE	XMLV	MDY, RWK
Small Cap	SLYG, RZG, IJT, VBK	SLYV, RZV, IJS, VBR	SMLV, XSLV	SLY, RWJ, JKJ, NUSC, VIOO

Style Factors

To outperform the broad stock market, we need assets that have an upside over the S&P 500, even if only for a relatively brief period of time. Such assets exist in the form of market subsets, which trade increased profit opportunities for reduced diversification. Naturally, there are many ways to segment the market. Morningstar introduced the Style Box, which partitions the total market by company capitalization and investment style. The table above shows a few such style factors, along with a selection of representative ETFs.

The rolling returns chart illustrates how this this structured way of segmenting the market leads to significantly wider spreads between the best and the worst performing funds. This leads to a somewhat surprising result: at nearly all times, at least one of the style factors provides positive rolling returns. This equates to a tangible potential for tactical strategies, allowing investors to profit more and lose less, if they can rotate between assets in time.

Economic Stage	Characteristics	Outperforming Sectors
Expansion	Economic output and corporate earnings are growing	Energy, financials, and industrials
Peak	Economic output and corporate earnings are slowing	Information technology and health care
Contraction	Economic output and corporate earnings are negative	Consumer staples
Trough	Economic output and corporate earnings are recovering	Materials and consumer discretionary

Industry Sectors

Style factors are only one way to segment the total stock market. Industry sectors offer another fine-grained method of segmentation. While the economy goes through cycles, each with expansion, peak, contraction, and trough stages, certain industry sectors do better than others. As a result, industry sectors show pronounced differences in their performance. The table above shows the relationship between economic stages and outperforming sectors.

Industry Sector	Representative ETFs
Materials	FMAT, RTM, VAW, XLB
Communication Services	FCOM, EWCO, VOX, XLC
Energy	FENY, RYE, VDE, XLE
Financial	FNCL, RYF, VFH, XLF
Industrial	FIDU, RGI, VIS, XLI
Technology	FTEC, RYT, VGT, XLK
Consumer Staples	FSTA, RHS, VDC, XLP
Real Estate	FREL, EWRE, VNQ, XLRE
Utilities	FUTY, RYU, VPI, XLU
Health Care	FHLC, RYH, VHT, XLV
Consumer Discretionary	FDIS, RCD, VCR, XLY

There is a range of ETFs available to represent the various industry sectors. Each of these ETFs is diversified across at least 20 titles, all members of the S&P 500. This way, the funds can greatly reduce the individual company risk. It is worth pointing out that this doesn’t always work. The funds typically rebalance their holdings about once a quarter, which might not be often enough in fast-moving markets. As an example, in early 2021 the Consumer Discretionary ETF, XLY, became significantly overweight in GameStop as its price increased more than tenfold during a meme stock frenzy.

The rolling returns of the various industry sectors show an even broader spread than the style factors. At almost all times, there is at least one sector significantly outperforming the S&P 500. Consequently, investing in industry sectors offers outstanding opportunities. Assuming a tactical strategy can continuously rotate into the best performing asset, it could deliver outsized returns and stay positive throughout the economic stages.

Country	Representative ETF	Relevant Index
China	GXC, MCHI	SSE Composite Index
Japan	JPXN, EWJ	Nikkei 225
Germany	DAX, EWG	DAX
India	PIN	BSE SENSEX
United Kingdom	EWU	FTSE 100
France	EWQ	CAC 40
Italy	EWI	FTSE MIB
Canada	EWC	S&P/ TSX Composite Index
Brazil	EWZ	Bovespa
Russia	currently uninvestable	MOEX Russia Index
South Korea	EWY	KOSPI
Australia	EWA	S&P/ ASX 200

World Stocks

According to Harry Markowitz “diversification is the only free lunch in finance.” In this spirit, looking beyond U.S. investments and including international stocks seems a natural conclusion. The table above lists the twelve largest economies and representative ETFs to invest in them, along with the most-relevant indices for these markets.

The chart above shows the range of rolling returns for the international markets. We can see that there are plenty of opportunities for international investments. However, the periods of ex-U.S. outperformance have often been short-lived, making it difficult to profit from these opportunities. Even worse, it seems that in recent years the magnitude of opportunities has waned, and world markets seem to increasingly mirror the U.S.

I believe the landscape regarding international stocks has changed in the past 15 years. In an increasingly globalized world, the regional markets are intertwined with each other, and there are only very few large-cap stocks that are not tightly linked to the U.S. economy. This limits true ex-U.S. exposure mostly to small-cap stocks and emerging markets. But, unfortunately, investing in such assets adds further risks, including political and foreign exchange, making these assets riskier and more volatile than the S&P 500.

In summary, the opportunities offered by ex-U.S. investments don’t seem to justify the additional risks. Investors seeking opportunities for outperformance are likely better off investing in U.S. stock market factors and sectors.

Individual Stocks

Buying individual stocks is the bare-metal way of investing in the stock market. By identifying rising stars early, investors can reap outsized profits. The chart above illustrates how the tremendous opportunity of investing in S&P 100 stocks dwarfs the returns of the S&P 500 index. And while these returns are still influenced by bull markets and recessions, there hasn’t been a period in the past 30 years where not at least one stock showed positive rolling returns.

The table above shows some of the largest single-day gains observed in S&P 100 companies since 1990. Most investors wish they had foreseen these developments and reaped some of these gains. But wherever there is light, there is also shadow, and these profits don’t come for free. The table below lists some of the largest single-day losses.

Curious investors are likely familiar with many of these names. Most of these outsized market moves stem from bankruptcies, lawsuits, mergers, and acquisitions. It is crucial to notice that extreme gains and losses can happen in any industry and at any time. While the bursting of the dot com and housing bubbles have been among the most noteworthy events in recent history, they have not been the only ones.

Regardless of how good our trading abilities might be, it will be hard to always stay clear of big losses. To protect against such losses, a minimum level of diversification is required, and investing in no less than five stocks is already a significant step towards reducing the individual company risk. Unfortunately, there are limits to this diversification. Stock shares are often expensive, and single shares of high-flying stocks can cost $1,000 or even more. As a result, creating a portfolio with ten or more individual stocks while keeping the asset weighting reasonably accurate can require a minimum investment of $100,000 or more.

Realizing the potential of investments in single companies requires frequent trading. Unfortunately, company shares are (unlike ETF shares) a scarce resource. Therefore, orders can only get filled if there is sufficient market liquidity.

But even though many individual investors consider themselves only a small fish in the pond, with their trades not making a difference in the market, the table above illustrates that this might not always be true. While at the top of the S&P 500, stocks trade with a daily volume of ten billion dollars or more, this liquidity quickly wanes. At the bottom of the S&P 100 stocks already trade no more than five hundred million dollars. And at the bottom of the S&P 500, the trading volume dips below fifty million dollars.

Such low volume will already severely limit the capacity of any trading strategy. For this reason, I believe that investors are well-advised to stick with the S&P 100 (or the Nasdaq-100 for that matter) and stay away from actively trading mid-cap or even small-cap stocks.

In summary, investing in individual stocks leads to more difficulties than most investors are willing to bear. Consequently, I believe that individual stocks should not play a dominant role in an investor’s portfolio. Instead, investors should use funds for most of their portfolio, and only add individual stock investments to turbo-charge an already solid portfolio.

Type	Exposure	Pro	Contra
Broad U.S. Market Indices	Cap-weighted index representing broader stock market	* Broad diversification * most docile behavior	* Average returns * Overweighting largest companies
U.S. Style Factors	Indices representing total market segmented by capitalization and styles	* Limited opportunities for outperformance * Good diversification	* Requires asset rotation
U.S. Industry Sectors	Indices representing total market segmented by industry sector	* Better opportunities for outperformance * Behavior of sectors linked to phases of economic cycle	* Reduced diversification * Requires swift sector rotation
International Stocks	Indices representing ex-U.S. companies	* Some opportunities for outperformance * Possible additional diversification	* Outperformance often very short-term * Globalization links performance to U.S. markets * Introduces additional risks factors
Individual U.S. Stocks	Shares representing individual company investments	* Significantly increased opportunities for outperformance	* Much increased risk * High minimum investment * Requires high-quality stock-picking

Compare & Contrast

The table above compares the various ways to invest in the stock market. The broad market indices provide the most balanced exposure to U.S. stocks and average returns through their high level of diversification. It is possible to outperform these indices by reducing diversification, and at the expense of higher risk and faster changes in sentiment. This behavior is more pronounced with market sectors than with capitalization and style factors and culminates in individual stock investments.

International stocks have historically also offered additional opportunities. However, these seem to have faded in recent years and an increasingly globalized world. Furthermore, international stocks expose investors to additional risks, including political and currency risks.

Factors that Move Stock Market Prices

When allocating funds to the stock market, investors are expecting a somewhat bumpy ride towards capital appreciation. In this section, we look at some of the factors that move stock prices.

Economy

The stock market and the economy have a complicated relationship. And while there are lots of theories explaining the various mechanisms and effects, the interaction between the two remains murky. However, my favorite quote illustrates things in a tangible metaphor:

There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch.

But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog and not the owner.

Ralph Wanger, former portfolio manager of the Acorn Fund

With the stock market representing the major participants in the U.S. economy, it is hard to imagine how either of the two can make significant moves without affecting the other. However, there is a considerable difference. The gross domestic product is a coincident snapshot of the state of the economy. In contrast to that, the stock market values future economic growth. Therefore, the stock market’s moves depend much more on the anticipated future than the situation at hand.

When looking at the economy, recessions are of particular concern. These are relatively short periods of economic contraction. Because it is hard to identify recessions in real-time, the National Bureau of Economic Research (“NBER”) employs a business cycle dating committee, which dates recession periods in hindsight. This recession indicator is available through the Federal Reserve’s Economic Data (“FRED”).

Most investors intuitively understand that recessions are challenging times for holding stocks. By charting the S&P 500’s price development since the beginning of the economic stage, we can visualize this. The chart above shows how recessions typically go hand in hand with bearish stock markets.

However, there are limits to this method. At the end of all recessions, we see an uptick in the stock market. Here, the markets anticipate the end of the recession, and start to recover before recessions end. Averaging the daily returns independently for growth and recession periods quantifies this effect:

Again, we see how the stock market is, historically, performing much better than average during growth periods and much worse during recession periods. Because of the timing mismatch between stock prices and economic indicators, we see that annualized stock performance during recessions seems less intimidating than the actual losses during these periods. In summary, investors should be aware of the current economic stage. While often lagging the stock market, the economy provides solid confirmation of recent price trends.

Inflation

Other than a recession, inflation is a close second in investor’s concerns. In a nutshell, inflation describes the devaluation of the investor’s home currency. This devaluation leads to a chain reaction: prices for goods increase, consumers purchase fewer goods, corporate profits decline, and the economy slows.

Because of these adverse effects on the economy, the Federal Reserve keeps a close eye on inflation. Through its monetary policy, the Fed aims to keep inflation at a target rate of about 2%. This monetary policy creates a link between inflation and interest rates: Interest rates tend to rise with inflation.

When looking at corporate cash flows using the discounted cash flow method, rising interest rates imply that today’s cash flows have a higher value than tomorrow’s cash flows. Stock market investments are likely to be affected as follows:

• Value stocks with stable current cash flow do better than growth stocks aspiring for future cash flows.
• Dividend payments most likely won’t keep up with inflation, putting high dividend-yield stocks at a disadvantage.
• Companies owning hard assets are better off than those in the process of developing intellectual property.

Because of this complex relationship, there is no simple answer to how inflation might affect specific stock market investments. Overall, stocks are less affected by inflation than many other asset classes.

The table above shows the average returns of the S&P 500 during high and low inflation regimes. The chart clearly suggests that market returns during periods of low inflation are significantly higher than during periods of high inflation. However, this analysis is biased by the fact that the largest companies in the S&P 500 are all highly leveraged technology firms.

Volatility

Volatility is a measure of the ‘unsteadiness’ of returns. Typically, we express volatility as an annualized price move. We can calculate historical volatility with only a little bit of high-school math. However, this measure, just like most quantitative indicators, is backward-looking. As investors, we are typically more concerned with the future than with the past.

In contrast, implied volatility, captured through the VIX index, is a measure of expected future price moves, expressed as an annualized percentage. As we cannot predict the future, the VIX uses a different methodology to estimate future volatility: the pricing of options. Institutional traders often use options to hedge portfolio risks, much like an insurance policy. The VIX calculates implied volatility based on the premiums paid for such options contracts.

Consequently, we can interpret the VIX as the market sentiment among institutional traders. It is worth pointing out that even institutional traders cannot predict the future and that implied volatility often closely matches historical volatility. Sometimes, however, significant upcoming events, e.g., presidential elections, cast their shadows ahead and drive implied volatility up.

From the charts, we can see that VIX indeed possesses predictive powers. In times of low to moderate volatility with VIX readings below 25, we see the stock market advancing nicely and without severe pullbacks. These periods can last for several years.

In times of high volatility with VIX readings above 25, we typically see deep drawdowns. These periods are most often brief, ranging from a few days to a few months. The stock market’s reaction to bad news is often faster and more violent than its response to good news. That’s why we often refer to the VIX as the “fear index.” The following table illustrates market performance in high and low VIX regimes:

On average, the VIX reads just below 20. About 80% of the time, volatility ranges below 25, with annualized returns far exceeding the average. Only about 20% of the time, volatility reaches 25 or above, with profoundly negative returns.

With these properties, the VIX provides easily tradeable signals, which foreshadow the road that lies ahead and can protect investors from steep losses.

News & Uncertainty

We are bombarded with market news every day, telling us about the stocks that made headlines that day. It is very tempting to invest in these stocks – but you should resist. Because stock returns are, in the short-term, mean-reverting, chances are high that the markets overreacted and that those outsized gains the news anchor raves about even out within just a few days. Also, this type of news is notorious for suggesting what to buy, but much less when to sell. Overall, the news cycle is not well aligned with the stock market. The news business is about reporting what has happened, while the stock market is driven by the anticipation of the future. However, these two views coincide when speaking about uncertainty.

The Federal Reserve provides and maintains data series about virtually any topic one can think of. One of the many fascinating series quantifies equity market-related uncertainty. This series is based on the proportion of newspaper stories mentioning the economy and stock markets in the context of uncertainty.

The chart above shows that the news-based index has good accuracy in distinguishing short flat or downwards periods from longer upwards trends. The table below shows that this index is highly selective, even though not quite as good of a predictor of market fear as the VIX.

Stock Market Investments as a Portfolio Component

Stock market investments offer tremendous opportunities for high returns. However, as the economy cycles through its phases, these high returns are met with potentially significant losses, often wiping out years of progress. Investors often underestimate these risks, anticipating their stock market investments to yield returns close to 10% per year; the average we have seen in the past 30 years.

The Monte Carlo chart shows that this is, unfortunately, far from the truth. To have 95% confidence of breaking even, investors must stay invested for almost seven years. After investing for ten years, the 90% confidence interval spans from 1.9% to 18.9%, and after twenty-five years, returns still range between 4.8% and 15.7%. Further, typical recessions will have a drawdown of 35% or more, and recovery from such losses might easily take ten years.

There are multiple problems with an investment with these characteristics. For once, the high risks and the deep drawdowns of stock market investments often make it hard for investors to stay the course. Instead, they are tempted to second-guess their investment decisions, and de-risk their portfolio after such drawdowns, leading to further long-lasting damage. Further, the stock market’s dependable returns are rather low, making aggressive investments in stocks a poor choice when investing toward a goal, or for income.

There are two main avenues to address these issues: diversification across asset classes, and tactical management. Both routes are valid, and the direction of choice depends on the investor’s stance on the efficient market hypothesis.

The conventional approach is diversification, as described by Harry Markowitz, the father of modern portfolio theory. Here, investments in the stock market are combined with investments in other asset classes that have a low or even negative correlation. The result are strategic portfolios, typically combining up to ~70% stocks with bonds, precious metals, and hard assets. These portfolios typically have slightly lower average returns than an investment in the stock market but in exchange offer significantly lower volatility. As a result, the dependable returns of these portfolios often outperform the S&P 500. I will introduce such portfolios in the chapter about strategic investing.

The second approach, which is much closer to my heart, is to improve the characteristics of stock-market investments with tactical management. Instead of investing a portion of the portfolio in the stock market and then staying the course regardless of the road ahead, we adjust the asset allocation based on recent price moves, market sentiment, and the economic outlook. By doing so, we can reduce the effect of major market downturns, and improve the portfolio performance.

What makes this approach appealing is that it unleashes new opportunities. For once, tactical portfolios can have a larger allocation to stocks than typical strategic portfolios, because they can manage the investment risks. Further, tactical portfolios can invest in smaller subsets of the market, including style factors, industry sectors, or even individual stocks, which allows them to outperform the market. By combining these aspects, tactical portfolios can cover a broader range of characteristics to better address an investor’s needs. I will discuss tactical management in a later chapter.