Last Year Was Easy for Stock Investors

Stocks That Bite

Beating the 2015 stock market required one good decision: Own the FANG stocks--the giant Internet companies of

This year, of course, is different. The profits have already been made with the FANG stocks. Realistically, how much more can they grow? Apple and Google are the planet’s two largest companies by market capitalization (perhaps the universe as well, but Morningstar research is insufficient for the task), at more than half a trillion dollars each. They won’t be doubling their worth again anytime soon. Amazon has never made as much as $1 billion in a fiscal year yet is valued at $300 billion. Even considering the company’s rapid top-line growth and its ability to transmute revenues into profits when it so chooses, that is an optimistic valuation.

So, unlike 2015, this year won’t be mastered by understanding a single trend. The successful 2016 investor will need to make many correct decisions. Fortunately, those decisions will be smaller in ...

All right, I confess: This argument is nonsense. It feels as if it's correct--indeed, even as I wrote those sentences while knowing them to be false--but this notion of last year being easy and this year being hard is flat-out wrong.

Every year people look backward, see a pattern, and conclude that the previous period had been simple to navigate. All investors had needed to do was assume credit risk, or avoid technology, or shift into defensive stocks, or whatever. There is always a one-sentence explanation for the past 12 months, with many pages required to discuss the next 12. Inevitably, last year rewarded trend followers, while this year will favor stock-pickers.

Balderdash. Let’s consider last year. Many reporters, market strategists, and other observers have written that the four FANG companies single-handedly (four-pawedly?) rescued the S&P 500 from a 2015 loss. Without those companies, the index would have dropped just under 1% on the year, counting dividends. But thanks to the FANGs, the S&P 500 was able to extend its winning streak to seven straight calendar years (although admittedly, the losses in that eighth year, 2008, were large enough to spread around for long into the future).

Been There, Done That That is how the tale is told. The reality, however, is something altogether different. Earlier this year, AQR's Cliff Asness put the FANG theory under the microscope and found that it failed. "It is true that a few stocks bailed out the capitalization-weighted [S&P 500] index last year," he wrote. "But it's also true in most years. It's always directionally true, that's just math, and in 2015 it was true by just about the average amount ... Considering all the hype, it's surprising how not surprising 2015 was."

In other words, it’s normal for a handful of stocks to account for 2 or 3 percentage points' worth of the S&P 500’s annual total return. On average over the past 20 years, the four companies that have had the greatest impact on the S&P 500’s calendar-year results have contributed 2.2 percentage points of profit. Last year's total: 2.4 percentage points. Thus, as according to the effect of the four most-impactful stocks (which were not all FANGs, by the way), the 2015 stock market was only slightly narrower than is typical.

Indeed, by other measures, last year’s market was actually broad. As the number of stocks in the analysis increases, 2015 flips from having been moderately narrow to being distinctly broad. The 20 stocks of greatest effect in 2015, for example, gave the index 5.0 percentage points of gains. The 20-stock average for the past two decades is well above that, at 6.3 points. Thus, being correct about the most important 20 securities in the index was less important last year than it customarily is.

(For those wondering about the narrowest year of the analysis, that was 1999. That year, the five largest contributors donated 6.7 percentage points to the index, and the top 10 a whopping 11.0 points. Such was the New Era--a period of speculation, excess, and exuberance that outglittered the giddiest of 2015’s technology-stock follies. The world as we knew it truly was ending along with the millennium. Or, at least, so it seemed at the time.)

Asness’s conclusion: "The bottom line is to be wary of anecdotes even when (maybe especially when) they're repeated again and again as conventional wisdom. In this case, some pundits actually scored a rare double bogey. They got the reasoning behind the anecdote wrong. Again, while it's not my focus here, it's still the cap-weighted indices that count and the number of stocks that go up versus down. But in this case, they even seemed to have gotten the anecdote itself wrong."

To which I would add, beware hindsight bias! If anecdotes are temptations, then anecdotes that use rear views are the devil’s own brew. It's very easy to believe, aided by the vision of hindsight and the power of a story, that the previous year's stock market would have been straightforward to navigate, for those who were smart or lucky enough to foresee the trend. It all seems so obvious. But it is not. Indeed, as with the fable of FANG, the trend may not have existed at all.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.