There are 1,500 companies reporting results this week, a flood of earnings releases all seeking to differentiate a story, a company.

At the same time, the Market Structure EDGE quantitative test portfolio limited to just five stocks could find only four, signaling a shift to cash.  Our Momentum portfolio at EDGE has zero components. Out of 3,500.

That data says one should short the market at the very time most National Market System stocks are reporting earnings.

There are two lessons for issuers and investors.

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Photo 68281572 © Macgyverhh | Dreamstime.com

The fact is most stocks don’t deliver reliable returns.  Our model portfolio above seeks out liquid large-cap momentum stocks using quantitative market-structure criteria. We limited it to five components so we could vet results more easily. But the model couldn’t even find five.

Too few outperformers is a problem for the entire stock market. 

The Investment Company Act of 1940 requires funds to direct 90% of assets at purposes outlined in prospectuses. A fund can’t own just one stock, such as NVDA. So say it owns a hundred.  It’s mathematically probable that most of those will be average.

Let’s say five outperform.  That means 95 stocks could be dragging the fund’s performance down. But it can’t sell the bad ones and continue to deliver the thesis in the prospectus.

This is a dilemma for the market that Exchange Traded Funds solved. 

Well, ETFs also eliminate the three core costs of managing money: customer accounts, taxes, commissions. Separate story.  I’ve written often about it at the ModernIR blog.

ETFs are collateralized derivatives – like mortgage-backed securities.  They’re substitutes for underlying stocks.

But ETFs can shrink that basket of stocks to a handful of best performers.  It’s not the only reason but it’s a major contributor to the outperformance of the Magnificent Seven that we used to call the FAANGs before Facebook changed its name.

And META is a great example. In November 2022, there was no more loathed stock in the market.  Mark Zuckerberg was roundly panned for gambling the business on something that doesn’t exist – the metaverse.

Today the most-loved stock in the market is META. Rational? No, META landed back in a bunch of ETF baskets because it was available and had the right characteristics.

ETFs specify a basket of securities they’ll take for collateral, a statistical sample of an index, model, portfolio. They won’t own everything. Heck, the basket could be five stocks.  Even if it’s twenty, the ETF sponsor – say, Blackrock – could dump the bad stuff and keep the good ones. (That’s why you can’t match the ETF’s performance.)

And ETF shares are infinitely elastic, like Federal Reserve Notes. As many as needed to accommodate inflows can be created and tied to the same underlying collateral.

The only requirement? More of the same stocks. It makes for an easy way to promote the outperformers.

Top five S&P 500 stocks year-to-date? NVDA, META, PANW, TSLA, RCL. The S&P 500 is up 10% thus far this year, but just 40% of its components are positive at all.  Nearly 300 have declined.

The bottom five – SEDG, ENPH, MRNA, FMC, DG – have themselves been top performers in the past.  All are down more than 50%. Should they be worth half what they were? Well, META was.  So was NVDA last year.

This is not rational. It’s Demand and Supply driven by Passive Investment.

Public companies, you’re driven by Passive Investment, not Story. As I’ve written before, you have about a 1% chance, statistically, of differentiating yourself and outperforming. You have a 99% chance of being average.

Which is great news!

Passive money buys averages – the characteristics of the market. And buying beta, the performance of the market, is inexpensive. Likewise, being beta is easier and vastly more likely than being alpha.

Yes, ETFs will distort Demand and Supply by permitting more money to chase the same underlying goods. Those outperformers then distend the benchmarks (and mask underlying weakness).

But follow me here.

Do you go through excruciating machination every quarter chasing the buyside and sellside, crafting just the right words in your release, your earnings-call transcript, that you hope will make you the 1%, and it doesn’t work?

Try something new.

Try being beta.  It’s what the money wants. The odds favor you.

Stock-pickers as a caucus (a nod to what may be an emerging solution to the Speaker stalemate in the US House of Representatives) lose votes every year. They have fewer funds to manage. Every year.  Sure, there’s an outlier here or there. But think of Actives, long-onlys, as a constituency. They lack the votes.

They’re net sellers.

Trying to attract sellers as buyers is unproductive. Be productive. Be beta.

Investors, you can only beat the market by marginalizing its volatility. How? Buy and sell the same stuff everyone else owns – at different times than they do. Want to know more? Use EDGE.

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