Economy & Markets

The beginning of 2018 promised to be more of the same from 2017, as stocks propelled themselves higher on tax cuts and a business-friendly environment in Washington. But the year has been a surprising disappointment for many. Instead of continuing on their steady upward trajectory, stocks had a turbulent 2018, rocked by rising interest rates, economic slowdowns in China and elsewhere and trade tensions and political uncertainty at home. The markets whipsawed, rising to a record in January, then correcting through the spring only to rebound to more record highs and then finishing off the year in a downward spiral.

As of mid-December, just about any type of investment, from stocks to bonds and commodities, were down year to date. That's even worse than the financial crisis, when at least government bonds held their own. Historically low interest rates in the last decade and the Fed's efforts to pump liquidity into the system helped lift stocks and enabled companies to borrow money to buy back their own shares and expand. But now that the Fed is lifting rates and backing off its easy money policy, the party in stocks seems to be ending.

As of Thursday, the S&P 500 was down 7% this year and most of its sectors, except for healthcare, were also down. The worst decline happened in the last few months, with the index down 14% over three months.

Once high-flying tech giants like Facebook and Google's Alphabet have led the tech-heavy Nasdaq down 4.5% this year, and over 18% over the last three months.

Uncertainty, a lot of it connected to policy decisions in Washington, is exacerbating the volatility. First, it was an escalating tariff conflict with China and trade tensions with Canadian, Mexican and European trade partners. Then it was President Donald Trump's criticisms of Federal Reserve rate hikes. In the last few weeks, it has been a government shutdown and the prospect of a Democrat-controlled House of Representatives causing uncertainty.

It was enough to push the S&P into a bear market as of Christmas Eve, meaning it was down at least 20% from its most recent high.

Wall Street analysts still see the index rising next year. Or at least they haven't significantly slashed their outlooks for year end 2019. They are likely waiting for a clearer picture on interest rate hikes and the progress of trade talks with China.

Some numbers at the end of 2018:

1. The number of jobless claims continued to inch lower, but consumer confidence showed a slight tick lower, too.

2. US home price growth slowed in October, a likely consequence of higher mortgage rates having worsened affordability and causing sales to fall.

3. The U.S. economy slowed in the third quarter a bit more than previously estimated, but the pace was likely strong enough to keep growth on track to hit the Trump administration's 3 percent target this year.

4. Orders to U.S. factories for long-lasting goods rose at a modest pace last month, but the gain was driven entirely by demand for military aircraft. Excluding transportation equipment, orders fell.

5. The Federal Reserve said it now expects just two rate hikes in 2019, one less than it had previously forecast in September.

6. Personal-consumption expenditures, a measure of household spending on everything from Netflix subscriptions to Legos, increased a seasonally adjusted 0.4% in November from the prior month, the Commerce Department said on Friday. That made for the ninth straight monthly increase in household outlays.

7. Businesses in the U.S. are less optimistic about the outlook for the coming year than they were 12 months ago, though many still expect sales, hiring and investment to rise in 2019, according to an ISI survey.

Recommended Reading

It's too soon to say whether the shift from growth to value is finally here, but an article in Advisor Perspectives offers a few thoughts on this being the end of value's "dark winter." Rising rates are good for value stocks, for starters. They push up the discount rate that applies to future cash flows. Also, the discount at which value stocks trade relative to growth is deeper than usual, and is due for a correction. There are also opportunities in diverse sectors, including consumer discretionary, technology and materials. Value outperforms growth in down markets, as well. Read more here and see below for links to blog posts and articles you may have missed.

M&A Value: A Harvard Business School doctoral candidate recently looked at the usefulness of independent valuation experts in deals, according the Barron's. The author concluded that directors and shareholders would do well to pay attention to these valuations. Differences between the acquisition price and value can be predictive. Read more

Underperforming Perspective: Larry Swedroe talked about how to deal with underperforming investments in a recent article in Advisor Perspectives. He offered data to support the notion that investors should build their strategies around risk-adjusted returns and diversification across unique sources of risk. Read more

Qatar Fund: Two royals are in charge of Qatar's $320 billion investment fund, according to Bloomberg. Until recently, the fund has been reluctant to invest in venture capital or technology but the new leadership is seen as a sign of the growing importance of deals with Russia and China. Some of the fund's investments include Uber and Flipkart. Read more

Quant Struggles: Some traders at quantitative fund D.E. Shaw have struggled to make money this year, according to The Wall Street Journal. The long-short equities group, with annualized returns of 40% since 2013, has lost about $100 million through mid-October. Read more

Pure Play: Pure factor ETFs, which stick close to their academic definition, perform well in a down market, according to Bloomberg. Some ETFs dilute factors "to the point where they mostly just deliver market returns." Advisers don't like the high tracking error of the purer funds or lack the patience needed to "truly capture a factor," it says, but suggests that a bear market could change the landscape. Read more

Big Squeeze: JP Morgan's Marko Kolanovic, well-known for timely calls that have put him at the top of the analyst rankings for a decade, is talking about a year-end "rolling squeeze," according to an article in Bloomberg. This is in large part because of a surge in corporate stock buybacks after earnings. UBS analysts have also pointed to buybacks as a primary driver of equity market rallies. Read more

Volatility Problems: Even over a decade, investors could underperform their benchmarks, Mark Hulbert argues in a WSJ story. Volatility is the problem. Hulbert describes an experiment by professors Eugene Fama and Ken French that revealed various investment strategies had a good probability of falling short of their benchmarks. Hulbert cites value investing as one strategy that fits this pattern. Read more

Actively Weak: Bloomberg's Barry Ritholtz looked at mutual fund performance over the last year versus various benchmarks. Growth stocks are still trouncing value, Bloomberg reports, and small caps are beating large caps. Pros are finally beating their benchmarks. The overall percentage of active funds that outperformed their benchmarks rose from 36.6 percent to 42 percent. The article notes that the longer the time period examined, the "worse things look," reporting that at 10 years and 15 years, active management performance is significantly weaker. Read more

Technology Wins: Wealth Management recently ran an article about how the alpha generated by ETFs differs from that of actively managed mutual funds. Morningstar data showed that 54 active ETFs generated positive alpha over three years. Wealth Management looked at more than 25,000 portfolios to find ETF-like characteristics. The top performers were technology products. Read more

Volatility Play: Low volatility stocks attracted $46 billion in the last decade but some argue they are effectively bond proxies because they have benefited from low interest rates. CFA Institute recently ran an article looking at whether rising rates pose a threat to this asset class. It created a long-only portfolio of the top 10% of US stocks ranked by volatility and found that it outperformed the market since 1991. That makes a strong case for low-volatility stocks, the article says. Read more

Fintech Wins: Berkshire Hathaway manager Todd Combs recently led the conglomerate's two fintech investments, Paytm and StoneCo. Berkshire usually buys stakes in blue chip American companies like IBM and Coca-Cola but these fintech companies share an attribute that Warren Buffett looks for in investments: They dominate their local markets. Read more

News on Hot List Stocks

Argan declared a regular quarterly dividend of 25 cents a share payable Jan. 31 to shareholders as of Jan. 24.

Moody's Investors Service upgraded Respol SA's issuer rating and guaranteed long-term debt rating to Baa1 from Baa2.

Performance Update

Since our last newsletter, the S&P 500 returned -6.1%, while the Hot List returned -5.7%. So far in 2015, the portfolio has returned -27.1% vs. -6.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 165.0% vs. the S&P's 148.8% gain.

Views on Behavior and Investing

Humans approach investing with their own biases and behaviors than can hinder their success. The study of behavioral finance has blossomed in recent years as experts try to find ways to help investors overcome this natural tendency. What the discipline has discovered is that human behavior hurts investor returns more than other outside factors. People chase returns, they sell when they should buy and buy when they should sell, they follow the crowd without examining whether the crowd is right.

Validea's Jack Forehand recently interviewed the psychologist Daniel Crosby, who is the author of three books including The Behavioral Investor. Dr. Crosby recently became Brinker Capital's Chief Behavior Officer.

One of the difficult aspects of behavioral finance is measuring just how much an effect human behavior has on individual portfolios. The research varies on the subject, with some suggesting it cuts into returns by less than 1% a year and others suggesting it cuts 4% to 5% a year off performance. The way this is measured has also been the topic of considerable debate, simply because there are a variety of reasons investors act the way they do at any given time. Investors add money or withdraw from mutual funds for other than bad behavior, for example.

"Whether you think it's 1% or 4% (and I tend to think it's somewhere in the middle), we can all agree that fees, poor timing and improper product selection are at the heart of investor performance," Dr. Crosby told Validea.

His advice is to pay close attention to fees, diversify within and between asset classes, and perhaps most importantly, do less than you think you should do.

He notes that Morningstar found the best predictor of performance is fees. That may seem a little obvious. Paying too much to the fund for management eats into returns. An unwitting investor could easily give up 1% a year in fees and that would get us to the conservative end of the performance gap measures discussed above.

Diversification is another fail-safe for investors because it makes the risk of any one position less of a contributor to overall performance. When one investment is going bad, chances are other investments are balancing it out with good performance.

Dr. Crosby also noted the work of Meir Statman and others, who found that performance decreases with increased account activity, which underscores the importance of getting investors to stop trying to day trade their portfolios. This is the idea behind the so-called robo advisors, which are online brokerage accounts that encourage investors to put money into a mix of ETFs at regular intervals and then let the portfolios do all the work. One such firm, Betterment, recently estimated the behavior gap in the following chart:

Source: https://www.betterment.com/resources/betterments-quest-behavior-gap-zero/

All of the data and analysis in the field of behavioral finance hasn't put a stop to investors behaving against their best interests, though. Validea asked Dr. Crosby if he thought the problem was getting better or whether humans will always be limited in their ability to prevent this.

Dr. Crosby acknowledged that we might never fully eliminate the tendency of investors to make poor decisions. He calls it the "knowing-doing gap," the problem of accepting things that are difficult even if we know it's for the best. Smoking is an example of this. People know it's bad for health, and yet they don't quit. "Likewise, as investors get more and more information about the impact of their behavior, many will make better decisions, but there will always be a significant minority of the population that makes ill-advised decisions about their wealth, simply because it's emotionally expedient," he explained.

Advisors often have a rough time with this because clients refuse to stay the course and panic during rough times. It's not always easy to spot this behavior in new clients, either, despite questionnaires and other ways to measure a new client's risk tolerance. Many advisors focus on what clients would do in worst-case scenarios and at dollar terms instead of percentages. Validea asked Dr. Crosby if he had seen any better methods used by advisors to assess this client risk before it presents itself.

One of the things behavioral finance experts know is that humans tend to project the recent past into the present. A client who has recently lived through 5 years of 15% annualized gains is likely to expect that in the near future, as well. Obviously the reality would leave that client somewhat disappointed. Advisors who spend a lot of time managing realistic expectations are the ones with the most success at client relations during bad times. Some experience with market downturns also helps advance an advisor's understanding of how to relate to clients. "Advisors need to work with their clients to give them as visceral an understanding as possible of just how much bear markets can hurt," Dr. Crosby said.

Role playing using dollar figures can help gauge client reactions, he adds. It gives clients a feel for how volatile markets can be if they run through actual scenarios from the past.

Advisors can also be there to talk clients out of making bad decisions in the heat of the moment. "Education remains a weak predictor of good behavior and sometimes the only thing that will work is someone to reassure you that you're making the right choice in a moment of intense emotion," he said.

The aforementioned robo advisors may have a hand in reshaping investor behavior, particularly for the millennial generation they court. When Betterment started showing clients the tax ramifications of their decisions, it helped alter some behavior such as selling during down markets. But of course technology can't replace good old fashioned hand-holding in the event of a crisis. Validea asked Dr. Crosby what he thought about the ability of robo-advisors to change behavior.

Robo advisors have lowered fees in the industry, as have the ETF products they rely on to build their portfolios. What is still untested, because most of the robo advisors came to prominence in steadily upward moving markets, is what happens in a sustained downturn. There isn't any evidence yet of whether investors will continue to embrace the set-it-and-forget-it philosophy that made robo investing popular.

"I think that robo-advisors are wholly capable of figuring out who needs help and even providing them with research, nudges and advice around how best to proceed. What remains to be seen, since no robo has lived through a true bear market, is whether or not these nudges are as powerful as the personal admonition to stay the course from a trusted advisor," Dr. Crosby said.

That brings us to this idea of loss aversion. It's said that investors are more worried about losing money than they are about making money. That helps to explain why people panic at even the most temporary downturn, even if it's preceded by unprecedented gains. Nassim Taleb recently challenged the idea that loss aversion is irrational. He argued that since investors can't recover from losing all their money, it's perfectly rational to fear losses more than celebrating gains. Validea asked Dr. Crosby whether he thought this made sense.

In his recent book, The Behavioral Investor, Dr. Crosby wrote that one of the reasons homo sapiens flourished is we were more loss averse that some of the other species of humans. We were more scared of losing and quicker to up and leave at the sign of a threat. We were also more apt to prepare. But there are both rational and irrational ways this can manifest itself. People, fearing a bad patch ahead, save for a rainy day and that's a good thing. But others, fearing any sort of loss, steer clear of the stock market in favor of "safer" alternatives. This group may fail to keep up with inflation and eventually be unable to reach retirement savings goals. "The trick thing about loss aversion is that our worst fears can materialize as a direct consequence of trying not to lose."

In volatile markets such as we've seen recently, it can be tempting to pull money out and sit on the sidelines or flee altogether. But at Validea we have designed a disciplined, systemic approach to investing that tries to remove as much human bias as possible and take the fear out of investing. Times like now require rational-minded, cool-headed analysis of the risks and opportunities that will come with the new year.

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