Economy & Markets

Corporate profits are strong, and CEOs report the economy is strong, with customers spending money and business optimism running high. But rising interest rates and concerns about the effect of trade conflict on future growth spooked the markets in recent weeks, sending investors on a wild ride. At times like these, investors wonder if it's a temporary blimp or a fundamental shift. Notes from the Federal Reserve's recent meeting show the central bank is convinced it needs to continue raising rates to keep markets in check. They are optimistic about the economic expansion but concerned about the longer-term implications of tariffs. Corporate profits are likely to continue to be strong through the fourth quarter, but analysts are listening to what companies say about their 2019 prospects to judge whether the market still has more room to rise.

Some numbers:

1. Job openings hit a record 7.14 million in August, indicating companies could face more inflationary pressures ahead with a tight labor market.

2. The number of Americans on jobless rolls is at levels not seen since 1973 as new applications for unemployment dropped in the most recent week.

3. U.S. industrial production increased for a fourth straight month in September but momentum slowed considerably in the third quarter.

4. U.S. retail sales edged up 0.1% in September, punctuated by a big drop in spending at restaurants and bars, Commerce Department data said.

5. The Labor Department said import prices rose 0.5% in September, the largest increase since May.

Recommended Reading

If the markets are making you dizzy, Barry Ritholtz offers a tongue in cheek after-the-fact explanation for its recent moves in a column for Bloomberg. Hindsight being perfect, he points out that our human bias makes it difficult to predict market swings and we have overly optimistic beliefs in our own abilities to do so. "It almost goes without saying, but the less knowledge we are burdened with, the greater the degree of confidence in our forecasts." He also points out that despite the scary headlines, the market sell off brings us back to where things were in July. "This decline follows a market that has tripled since 2009, had zero volatility in 2017, and has continually confounded all experts who in one way or another couldn't explain why the market was as good as it was." Read more and here are some more blog posts and articles, in case you missed them:

Ominous Trends Morgan Stanley's chief U.S. equity strategist Michael Wilson sees "ominous trends occurring under the surface of the major indexes," Barron's reports. There's more potential for weakness than we may currently see. There are concerns about growth slowing in the coming months and next year due to Fed tightening, increased cost pressures and the risk of trade wars. Read more

Buffett's Way Forbes recently wrote about Warren Buffett's investment approach. Three major themes emerge: Investment versus speculation, margin of safety, and long-term investing. The approach is based on two of Buffett's favorite books, The Intelligent Investor by Benjamin Graham and General Theory by John Maynard Keynes. Read more

Starving Growth Cost cutting and higher prices can hinder a company's growth and harm its value, McKinsey & Co. writes. Cutting costs can starve a company of new sources of growth and undermine long-term performance, citing data from a recent study of 615 of the largest nonfinancial companies (from 2001 to 2013). Only about half of the companies were able to sustain a margin increase for four or more years. Read more

Global Value Peter Wilmshurst recently told Morningstar how his group chooses strong value stocks within an increasingly expensive global environment. He said it's harder to find value in the U.S. right now. They view the world from a sector standpoint and take a "bottom-up" approach. One example is the auto industry: "Autonomous driving, electric vehicles, ride sharing, three key themes. They will develop at different speeds in different markets. But you've really got to have a view on how those industry themes are going to develop." Read more

Cheap Benefits Cheap mutual funds may save investors from their worst impulses, Barron's says. High cost funds hit investors with expenses and then buying and selling at the worst time, it says, citing supporting data from a recent Morningstar study. CFRA director of mutual fund and ETF research Todd Rosenbluth told the paper that investors are more patient with strategies that cost less. Read more

Tracking Troubles Although tracking trends in financial markets was once a profitable investment strategy, The Wall Street Journal recently reported that this approach has fallen on hard times due to crowding. During the 1990s and 2000s, the article reports, these strategies enjoyed double-digit gains and, in 2008, were one of the few strategies to make money. The article also says "trend-following is one of the starkest examples of how strategies that once belonged exclusively to hedge funds and earned them huge profits are being copied and commoditized by low-cost replicators." Read more

Broad Portfolios The July issue of AAII Journal had an article talking about the common view that diversification beyond 10 or 20 securities is superfluous. It looked at a study that found investors with relatively small portfolios would benefit more from very broadly diversified, low-expense mutual funds or exchange-traded funds. Investors with larger equity portfolios could afford to hold individual stocks in a portfolio. Read more

Gotham Fund Barron's recently profiled the Gotham index Plus fund, which was created by Gotham Asset Management founder Joel Greenblatt to "marry the steadiness of index investing with the market-beating advantage of active management." The fund is up 15.7 percent after three years, beating the S&P 500. The fund invests in the S&P 500, and Greenblatt buys the most undervalued stocks in the index and shorts the most overvalued. Read more

Active Revival Is this now a time for the return of the active managers? Barron's quotes global macro strategist Vincent Deluard of INTL FCStone, who advocates for "identifying and investing in individual gems" that could potentially outperform indexes. Deluard says that the popular stocks in indexes tend to be more expensive, and overvaluation is leading to disappointing performance. Read more

Hot List Performance Update

Since our last newsletter, the S&P 500 returned -4.6%, while the Hot List returned -5.5%. So far in 2015, the portfolio has returned -15.1% vs. 3.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 208.7% vs. the S&P's 176.8% gain.

Latest Changes

The Challenges of Timing the Market Like the Pros

The recent market upheaval has many people turning to market legends for advice, and it's easy to see why. These famous investors have made their names successfully navigating the markets over the long-term, and have survived many declines over that time. Investors naturally want to soak in their wisdom about how to steer themselves through turbulent times.

People are naturally questioning where the long bull-market is in its lifecycle and wondering if they should shift strategies to prepare for a new reality. Everyone is looking for the magic sign that will get them out of harm's way by selling or keep them in the game by holding steady. People study technical trends and investor sentiment, others are looking at warning signals in the bond market, such as the infamous flattening yield curve.

There isn't any one indicator that can perfectly predict which way to go, however. All an investor can rely on is sticking to a well-considered plan that matches their own needs.

Howard Marks has a new book entitled "Mastering the Market Cycle: Getting the Odds on Your Side." In the book, the investing legend says the market has repeated similar cycles throughout history, and by knowing where we currently are in that pattern and adjusting accordingly, investors can improve their long-term returns.

Marks is right in saying that the markets follow patterns over time. But for most ordinary investors, figuring out where the market is in that pattern at any given time is more difficult than it would seem. They don't have the tools professionals have at their disposal to track technical trends, for starters. And even if the precise moment in time for the market can be accurately pinpointed, following the lead of market pros doesn't necessarily fit into a particular investor's individual circumstances. Understanding those unique factors is crucial for an investor to build a successful strategy that he or she can stick to over the long-run.

One way to measure the difficulty of following a given piece of advice is to look at how many steps it would take an investor to implement it, especially if it means shifting that investor's own strategy. Answer the following questions:

1. Where are we in the market cycle?

Not even experts can agree on how long the current bull market has been going. Many point back to March 2009, the bottoming out of the crisis-era market. Using that as the guide, the current bull is now the longest in history, having crossed that milestone in August. But others think a bull market starts when the previous highs are eclipsed. That definition makes this bull market much shorter. It's worth noting that bull markets last longer than bear markets. Marks believes the current bull market is in the "8^th inning," a baseball term indicating the regulation game is almost over. But that leaves a little room for extra innings.

2. What do I do about it?

Let's say for argument's sake that we are in the 8^th inning, and you want to start to brace yourself for the market's turn. Marks suggests investors take a look at their standard risk levels and begin to adjust things toward a more defensive posture. Marks does this for his own investors while still keeping them fully invested. But some investors might be tempted to make bolder moves - sell and put everything in cash, for example. But what Marks does is more gradual, showing investors that if they want to make adjustments, moving slowly is better. Timing the exact turn in the market is next to impossible and it is likely you are going to begin making changes well before the market actually turns. Even if you move gradually out of the market, it is likely to be tough to stick with the strategy when you inevitably underperform while the market keeps running. If you move out of the market entirely, it will be next to impossible.

3. When do I change?

The next step is bracing for change, and it might not go the way we thought it would. The sell-off could prove temporary, and stocks could rally to new highs. Or it could be the beginning of the next sustained bear market. The clear trend could take a lot longer to appear than we would like, or it could emerge suddenly with sickening volatility. Changes in the market would call for going through this process again starting with the first step. It would mean another judgement call about where we are in the cycle and a separate decision about what to do about it.

Marks ranks up there with Warren Buffett as being among the best gurus at providing guidelines investors can use to achieve success over the long-term. For those who can figure out where we are in the cycle, can implement a slow and gradual process to update their portfolios to reflect that, and can stay the course when they are wrong for long periods of time, this can absolutely work.

The cautionary note is that most investors don't fall into that camp. It's tempting to try to time when the next market turn will come, but investing is far from simple. Some of the biggest mistakes investors make are trying to predict when the market will fall, and sell out before they should. At Validea was have designed a systematic investing method using models based on the strategies deployed by several of the investing greats. Using these models gives investors a disciplined approach to investing that removes as much of the guesswork and human emotion from the process as possible. But what works for legendary investors doesn't always work for everyone else. Trying to adjust your portfolio based on market cycles is one piece of advice I think most investors would be better off avoiding.

Newcomers to the Hot List

Alliance Data Systems Corp. (ADS) - This provider of marketing and loyalty program software scores highly on the model tracking four gurus, including John Neff, Warren Buffett, Martin Zweig and Peter Lynch.

Repsol SA (REPYY) - The American depositary receipts of this integrated energy company score highly on the models tracking the styles of James O'Shaughnessy, Peter Lynch, Kenneth Fisher and Joseph Piotroski.

Thor Industries Inc. (THO) - This maker of recreational vehicles scores highly on the models tracking the styles of Kenneth Fisher, Joel Greenblatt and Peter Lynch.

UnitedHealth Group Inc. (UNH) - The healthcare giant scores highly on the models tracking James O'Shaughnessy, Martin Zweig and Warren Buffett.

News on Hot List Stocks

Alliance Data Systems reported third quarter profit of $296 million, or $5.39 a share. Adjusting for one-time gains and costs, EPS was $6.26 a share. Analysts had expected EPS of $6.25.

Moody's Investors Service upgraded the corporate family and senior unsecured ratings of Credit Acceptance Corp. to Ba3 from B1. The outlook is stable.

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

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