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  • Martin Fridson, CFA

The Impact of Surprises and Security Selection

Nobody’s 2020 forecast included the coronavirus outbreak.

In his hit television show of the early 2000s, comedian Sacha Baron Cohen posed as the dimwitted “hip-hop journalist” Ali G. He landed interviews with prominent people who were not in on the joke, getting serious answers to intentionally stupid questions. Ali G introduced astronaut Buzz Aldrin as the man who walked on the moon with “Louie Armstrong” and asked him whether people would ever walk on the sun. When Aldrin replied, “No, it’s too hot,” Ali G clarified, “I mean in winter.”

My personal favorite was Ali G asking National Security Advisor Brent Scowcroft whether the U.S. armed forces had considered nuking Canada. When Scowcroft recoiled at the suggestion, Ali G pointed out a benefit of his idea--the element of surprise. This is a roundabout way of introducing the month’s first theme—the impact of surprises.

It was no laughing matter in late January when financial markets reversed direction in reaction to a highly unfortunate surprise, the outbreak of a deadly coronavirus. The S&P 500, which was up 3% for the month as of January 17, dropped by 2% over the next 10 days. Equity prices recovered some of their lost ground in subsequent sessions, but the setback experienced through January 27 drove home the importance of unforeseen events.

In December, when market pundits listed the key market determinants for 2020, nobody predicted that a new disease would appear in Wuhan, China. If anything, the developments not foreseen by forecasters end up having more impact than all of those they do foresee, combined. In a well-functioning market, securities prices incorporate everything that is expected. Only the unexpected events, the surprises, have the power to move the market.

That brings us to this article’s second theme: Intelligent security selection is key to building a portfolio that can withstand shocks. Following 10 intra-month changes in direction, the ICE BofA Fixed Rate Preferred Securities Index finished January with a total return of 0.83%. But that’s a market-weighted average of the returns of that index’s 218 issues, which ranged from 4.77% to -10.14%. The January return on the preferred securities portion of your portfolio was probably a function of many fewer than 218 issues.

Top-down thinking has some merit, but selecting preferreds on the basis of “factors” didn’t guarantee superior performance in January. For example, selecting preferreds rated Single-A gave you about as good a chance of landing below the median as above the median. Four Single-A preferreds placed in the month’s top 109 performers and five in the bottom 109. Neither was maturity the silver bullet for selecting short-run winners. Of the index’s 95 perpetuals, 46 ranked in the top half and 49 in the bottom half.

Your long-term returns matter more than your results in a single month, but same point applies: An essential ingredient in good outcomes is rigorous, issue-specific analysis.

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