Economy & Markets

As the year winds down, analysts and traders are looking at two issues weighing on the markets. The first is the Federal Reserve's outlook going into 2019. Everyone expects one more rate hike this year, but expectations are mixed for how many more will come now that the Fed has signaled some caution on the subject. Rising rates have threatened to cut into corporate profits at a time when it is expected to slow after a year of fast-paced growth. The bond market has been obsessing about what short-term rates are signaling about the economy as they inch closer to the long-term rate. In the past, when short term rates jumped above longer-term rates, it's been a recession omen. The other big issue is trade conflict. The U.S. and China are working to resolve an escalating tariff dispute, putting a 90-day deadline on talks. Failure to achieve any kind of progress has been seen as a bad sign for markets next year. The Dow Jones Industrial Average, trading at a 15.8 multiple, has shed its gains for the year, as has the S&P 500, at a multiple of 17.5. Healthcare and utilities are leading stocks, while materials and energy lag the market.

Some numbers to watch:

1. Businesses are less optimistic about the coming year than they were a year ago this time, according to Institute for Supply Management's semiannual survey of purchasing and supply executives.

2. Job openings were 7.08 million in October, the second highest level, but there were just 6.08 million Americans classified as unemployed.

3. Private payrolls increased by 179,000, below the 195,000 growth expected by a Refinitiv survey of economists. The number also was a drop from the 225,000 in October and below the 203,000 prior monthly average.

4. According to the S&P Corelogic Case-Shiller National Home Price index, as of September, home prices were 53 percent higher than they were at the bottom of the market in 2012.

5. Commerce Department said U.S. construction spending fell for a third straight month in October. Analysts surveyed by Reuters had expected spending to increase 0.4%, but it fell 0.1%.

Recommended Reading

Some people are arguing that stock market leadership is passing from growth to value, but a lasting rebound of value is likely to require tougher overall market performance for a while longer, according to CNBC. Growth stocks are too big a share of the market to retreat quietly, it says, and there is a psychological barrier investors have to overcome to accept owning shares of companies that are permanently disrupted by technological change. A fourth quarter rally would likely involve the growth favorites represented in the Nasdaq and the big, defensive groups. For more on this read here , and see below for links to articles and blog posts you may have missed.

Bond Kings: Bloomberg columnists Nir Kaissar and Noah Smith recently debated whether U.S. companies have too much debt and whether that presents a risk to the economy. Read more

Rate Protection: Bargain shopping may not be a good idea when it comes to bond funds, according to The Wall Street Journal. Higher-priced actively managed funds are beating the index fund competition, largely because they are doing a better job protecting their portfolios from rising interest rates. Read more

Globe Trotting: Computer-driven hedge funds are combing the remotest corners of financial markets for any sort of advantage, according to Bloomberg. Commodity trading advisers are looking at everything from cheese and Turkish scrap steel to obscure chemicals or eggs in China. Read more

Berkshire Buyback: Berkshire Hathaway bought $928 million of its own stock in the third quarter of 2018. WSJ called this a rare move that indicated Chairman Warren Buffett sees a dearth of appealing investment options for his company's large cash balances. Read more

Melt-up Odds: In a January memo, Jeremy Grantham predicted a year-end melt-up that could take the S&P 500 to the 3,600 area, according to Financial Advisor. Grantham cited a Harvard research paper that said acceleration is a strong indicator of bubble activity. In October, as the melt-up didn't occur, Grantham said in an interview: "As soon as it became clear the president was waging a war on global trade, the odds dropped to 35 percent." Read more

Investor Caution: Ian Cassel told people at the Small-cap Discoveries Private Investor Conference in October that successful investing is counterintuitive to human nature. It means investors have to be able to sell losers or lean into winners. Most investors won't do the necessary due diligence. And the only thing more important than having an investment thesis is knowing what will kill that investment thesis. Read more

Year-end Prediction: Jeremy Siegel was on a podcast for the Knowledge@Wharton radio show and said investors shouldn't panic about the stock market's recent dips. His prediction was that stocks would be "either flat or up by as much as 10% for all of 2018." Read more

Beyond Hypothesis: MIT finance professor Andrew Lo believes that there are factors beyond those outlined in the efficient market hypothesis that influence market movements, according to CFA Institute. The traditional investment framework is not wrong, but it doesn't take everything into account. Read more

Defense Time: A recession in the U.S. isn't imminent but Oaktree Capital's Howard Marks believes it's time get cautious, according to Bloomberg. He told Bloomberg TV "strategies should still focus on remaining invested and position defensively, without piling into cash." Read more

Sustainable Investing: Nir Kaissar recently wrote in Bloomberg about how Yale University's $29.4 billion endowment could exit private investments it "deems unethical, extending a policy it has long applied to investments in public markets." But the article argues that the attention garnered by sustainable investing "hasn't yet translated into investment," at least as measure by the flow of funds into ETFs. Read more

Good Bets: Leuthold Group's Jim Paulsen recently told CNBC the market needs a 15% correction to reflect rising interest rates, peaking earnings, and slower economic growth, adding, "What we need is a lower valuation, I think, to sustain a different environment if this recovery is going to continue." He suggests utilities, consumer staples, and real estate investment trusts as good bets. Read more

Inversion Effect: Can the stock market can continue to rise after the coming yield curve inversion? A recent article concludes: "With such a high valuation, it will not take a very large adverse development to send it crashing-namely, faltering earnings, a recession, higher interest rates, etc." Read more

Hot List Performance Update

Since our last newsletter, the S&P 500 returned -3.2%, while the Hot List returned -7.0%. So far in 2015, the portfolio has returned -22.7% vs. -0.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 181.1% vs. the S&P's 164.9% gain.

Latest Changes

Learning from the Hierarchy of Investor Needs

With investing, certain skills have to be mastered first, as Morgan Housel of the Collaborative Fund discussed in a recent podcast with Chris Hill of The Motley Fool, They become the foundation for other skills that, taken as a whole, become the guidepost for investors to understand what is important and where they should be spending their time and energy.

This hierarchy of investor interests, as Housel called it, puts investor behavior at the bottom of a pyramid. Atop the bottom layer is asset allocation, then fees and transaction costs, security selection and then taxes at the top. The idea here is that the different levels overlap and can be used in the investment process to help make the best decision under the current circumstances.

Here is a look at the ways these various levels affect investors.

1. Behavior is the foundation and, thus, the most important layer of the pyramid. That's because it's difficult to put aside emotion and bias when it comes to making an investment decision. Often these behaviors and biases aren't easy to detect. Brian Portnoy's book, "The Geometry of Wealth," outlines six of the most influential biases that can derail even the best thought-out investing plans. The first is temperament. At the depths of the financial crisis in early 2009, investors were pulling billions of dollars out of equities and stock funds into cash and bonds. They were selling after the worst of the stock market decline, despite the age-old advice to buy low, sell high. It's a common pattern whenever the stock markets shed a significant amount in a short period of time. It also is an illustration that investors have an aversion to loss, feeling the downturn more than they celebrate the upturns. So they make the mistake of liquidating their losses and missing out on the early part of the eventual rebound. Investors who are able to control their emotions and focus on the long-term, understanding that stocks are volatile and can go through bear markets, are more likely to find success. It should come as no surprise that investors like Warren Buffett zig when everyone else zags, buying up at the time of maximum fear in the market. He did so in 2008 and encouraged others. Few followed him, at least immediately, but that kind of discipline is probably why Buffett is a billionaire. Investors can try to duplicate this success by using quantitative methods like we do at Validea that eliminate as much emotion and bias as possible.

2. The way investors construct their portfolios, or allocate assets, is the next layer of the pyramid from the bottom. V anguard research found that close to 90% of returns can be tracked back to a portfolio's asset allocation. A big bet on S&P 500 stocks in the last decade would win over other portfolios with more even weightings between stocks and bonds. But the same big stock bet from 1999 to 2009 would have lagged the diversified group. Investors tend to stick close to home when picking investments for their portfolios, meaning many are likely missing out on opportunities in international markets. The degree of U.S. versus foreign exposure is one of many decisions in the overall asset allocation policy, but understanding the role asset allocation plays in short and long term returns is vital as investors think about diversification and risk management.

3. Fees and transaction costs have a bigger effect on returns than many investors realize, and they are the third layer from the bottom of the pyramid. Stocks can gain and lose unpredictable amounts in any given time period, but trading fees and other costs tend to be fixed. A fund that produces a gross return of 10% a year, charges a 2% management fee and has a 250% annual turnover is going to produce a lower return than a fund that returns 10% a year, charges 0.50% and has 50% annual turnover. That's just simple math. Knowing that fees and transaction costs is important to understand because this has a direct impact on your bottom line.

4. Stock picking, the fifth layer, is fraught with potential mistakes. Investors are constantly looking for the as yet undiscovered next Apple, Walmart or Amazon. In reality few companies achieve the status these companies have. Investors also tend to buy the stocks of companies they know, going along with the Peter Lynch style of investing. But they risk overpaying for hot stocks when they do this, as witnessed right before the dotcom bubble burst. Many professional investors, including Warren Buffett, have advised people who don't have a lot of time to evaluate individual stocks that they should invest in indexes instead. But if investors do decide to actively pick stocks, they should follow a process both for buying and selling and stick to things they know, what Buffett calls staying in one's "circle of competence."

5. Taxes are the top layer of the pyramid. It may seem like an afterthought at this point, but taxes can play a significant role in returns. Take two investors with a $1,000,000 taxable portfolio. The first investor generates an 8% annual return over 20 years. The second investor two generates an 8% return but doesn't do it tax efficiently so he is on the hook for short-term gains each year. A quick calculation can show the difference: the first investor ends with $4.6 million while the second investor ends with $2.7 million (the 8% annual return turns into an after tax return of 5.2% assuming a 35% short term capital gains rate as an estimate). With that in mind, it's important to know the difference between short and long-term gains, how and when to harvest losing positions, pick funds that can avoid capital gain distributions and avoid wash sales.

Investors who understand each of these parts in the hierarchy will be better served and give themselves a better chance at long term success. Focusing on the things that matter the most - behavior and asset allocation - while rounding out the edges with those up the pyramid (fees, stock selection and taxes) is how most investors should approach their investments and decisions. At Validea we have developed tools and processes that help make this decision process more disciplined, allowing investors to minimize mistakes as they work toward their investing goals.

Newcomers to the Hot List

AppFolio Inc . (APPF) - This maker of cloud-based software for small and medium sized businesses fits well with the portfolios tracking the strategies of the small cap growth investor, Motley Fool.

Argan Inc. (AGX) - Shares of this industrial services company score highly on the models tracking the styles of Peter Lynch, Benjamin Graham and Kenneth Fisher.

Cavco Industries Inc. (CVCO) - This factory-made home builder scores highly on the models tracking the styles of James O'Shaughnessy, Peter Lynch and Martin Zweig.

CDW Corp. (CDW) - Shares of this information technology provider score well on the models tracking the styles of James O'Shaughnessy and Martin Zweig as well as the Validea momentum portfolio.

Lukoil ( ADR) (LUKOY) - The Russian oil production company scores well on the models tracking the styles of James O'Shaughnessy, Kenneth Fisher and David Dreman.

QuinStreet ( QNST) - This performance marketing company scores on the Validea momentum model and the Motley Fool's small cap model.

News on Hot List Stocks

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

Lukoil is considering a joint venture with Gazprom in the Nenets Autonomous District.

UnitedHealth Group renewed a contract with Envision Healthcare after months of discussions.

California's department of managed health care approved Cigna's merger with Express Scripts.

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The top scoring stocks not currently in the Hot List portfolio.

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