Market Insights: Outperformance

We often use the term outperformance to mean that an individual is getting better returns than the average in the stock market. So if the S&P 500 is up 1% and your portfolio is up 2% in the same period, then you are outperforming the market. However, Outperformance can be a much broader topic than just an individual’s return or a fund’s return measured against the market performance.

A critical measure of outperformance is your Sharpe ratio. The Sharpe ratio measures how much return an investor makes for every unit of risk that he or she takes. For example, if you achieved a return of 12% last year and your portfolio had an annualized standard deviation of 10%, then your Sharpe ratio was 1.2. A Sharpe ratio is greater than zero means that you make more money than you risk, which should be the goal of every trader and investor. A Sharpe ratio of less than one means you’re taking too much risk for the returns you’re achieving, while a negative Sharpe ratio means that you lost money or suffering negative returns.

Outperformance can also be found in assets and asset classes. Equities have largely outperformed bonds for several years, meaning that equity returns were larger than bond returns. However, it’s important to note that this doesn’t necessarily mean that bond returns were negative. If bonds returned 2% per year while equities returned 7% per year, then equities outperformed bonds, even though both had positive returns.

This is also called relative performance. In the above example, bonds had a relative -5% performance compared to equities, even though they had an absolute return of positive 2% -- they underperformed by 5%.

There is always a constant push and pull between different sectors, industries, and strategies in the stock market. Sometimes, so-called cyclical sectors are outperforming. In pullbacks, defensive sectors tend to outperform. It’s essential to keep in mind that this is on a relative basis. If the entire market is down an average of 10%, then the sector that is only down 3% is still outperforming the market by 7% on a relative basis, even though it’s still down in absolute terms.

Often, you will hear about value or growth being the place to invest. This means that, on a relative basis, one of those strategies is performing better than the other. One way to perform these comparisons is by going to TradingView.com/chart and entering a ticker symbol, followed by a forward-slash (“/”), followed by another ticker symbol. This will show you the performance of the first security relative to the performance of the second security.

Let’s check out an example:

If I do the above steps and type “IWM/SPY,” I’ll get a chart of the relative performance of IWM, the Russell 2000 ETF, as compared to SPY, the S&P 500 ETF. This tells me how small and mid-cap stocks are performing relative to large and mega-cap stocks. On a one-year daily chart, it looks like this.

From this chart, we can glean that at the end of 2020, small- and mid-cap stocks, generally referred to as growth stocks, hugely outperformed their large- and mega-cap peers. But that changed in mid-March, as inflation worries and rising interest rates raised concerns about the viability of future cash flows for smaller, riskier businesses. Since then, smaller growth stocks have been underperforming as investors dumped them for the safer and more stable businesses found in the largest 500 stocks.

If we look at just the last few weeks of the chart, though, we can see outperformance beginning to creep back into the Russell 2000. It appears to have bottomed in early May and has since started to rise again.

Is this signaling the beginning of a new rally for smaller stocks relative to their large- and mega-cap peers? Only time will tell, but the long and skinny of the chart above is that, when the chart is going down, you want to be out of smaller stocks and into bigger market cap companies. And when the chart is going up, the opposite is true. For now, I’m continuing to watch this space and looking for promising names with growing earnings and valuation multiples that have room for expansion.

In Closing

This continues to be a stock picker’s market, as equities remain the only game in town, and it all comes down to finding the right equities to buy long and sell short. Proper stock analysis is more critical now than it has been in a long time. Take your time, be thorough with your analysis, use sound risk management, plan your trades, and trade your plan.