Economy & Markets

For many companies and investors, the beginning of the year is a time to reassess expectations as earnings reports roll in and companies update analysts on their guidance. After tumbling badly in December, markets recovered some ground, but new concerns are emerging. Profit growth is not expected to be as strong this year as it was in 2018. Rising rates may be part of that, but there are also concerns about slowing economic growth and the hangover from last year's tax-cut-fueled profit boost. A partial U.S. federal government shutdown and seeming stalemate in Washington over spending priorities is only adding to the worry. On a positive note, worries over trade with China have eased in recent days as the two sides meet to negotiate key issues. And the Federal Reserve calmed fears about more interest rate hikes by indicating it would be flexible in its decision-making. The S&P 500 is trading at 19.3 times earnings, led by industrials, real estate and utilities. The Dow Jones Industrial Average is trading at a PE of 19.9.

Some positive numbers:

1. Job openings are declining but they still outpace the number of people looking for jobs by about 800,000. U. S. weekly jobless claims also fell more than expected last week, according to the latest from the Labor Department.

2. The Institute for Supply Management said the U.S. services sector expanded at a slower than expected pace in December, but is still above the level that indicates an expansion.

Some not-so-positive numbers:

1. Fitch Ratings warned of a possible cut to the U.S. triple-A rating if the partial government shutdown continues.

2. Several companies, including Apple, Constellation Brands, Samsung, American Airlines and FedEx have tried to temper growth expectations for this year but cutting their near-term revenue and earnings growth forecasts.

3. While Sears struggles to escape liquidation, other retailers are reporting disappointing numbers. Macy's reported weak holiday sales despite a strong Black Friday and lowered its 2018 outlook. That sent shares of several retailers down on Thursday.

Recommended Reading

Robert Shiller recently wrote in The New York Times that, "The more we learn about how people really think, the more we must rethink economic theory." He's talking about two studies last year that demonstrate how people change their beliefs when thinking about their financial futures. The ramifications of the 2008 financial crisis are still being felt. Worry that such an event could recur can put a damper on economic growth. That's because people aren't always logical when it comes to behavior and finance. People often believe that the most recent history will continue until it shifts, and then expectations will shift again. Read more about it here and see links below for more articles and blog posts you may have missed.

Following Cash: David Pearl said in Barron's that he's still following free cash flow as his performance yardstick of choice. That's because economic conditions are good, earnings are growing and free cash flow, which is what is left after obligations are covered, is a great indicator of a company's health. Read more

Commodity Play: Bloomberg reports that Goldman Sachs is predicting 17% returns in the commodities market in coming months. The firm expects a supply cut from OPEC, a rally in natural gas, and a boost to gold if U.S. growth slows, stoking demand for defensive assets. Read more

Timing Temptation?: Burton Malkiel looked at Howard Marks' new book "Mastering the Market Cycle" in a recent WSJ article, focusing on Malkiel's belief that the study of past cycles can keep us alert to recurring patterns. The book reflects Marks' confidence in understanding how investor attitudes toward risk change. Price drops increase aversion to risk, while price increases encourage risk taking. Malkiel also says he's concerned that the book may encourage market timing rather than periodic rebalancing of a diversified portfolio. Read more

Bond Glut: Advisor Perspectives recently ran an article about comments on the corporate bond market by DoubleLine Capital's Jeffrey Gundlach. In a podcast last November, Gundlach reportedly argued that the corporate bond market is facing excessive debt and an oversupply. The result is corporate and high-yield bonds were at or close to their most extreme overvaluation. Read more

Crystal Ball: There's been a lot of talk about a pending recession, notes a recent article in Bloomberg. Stocks have been acting in a way that has presaged slowing growth in the past, such as the gains in defensive sectors and the embrace of low-volatility names. But it also notes that analysts don't necessarily see a recession coming soon, but rather that the trends point to a healthy sell-off after a 10-year long bull market. Read more

Robo Style: Artificial intelligence may bridge the gap between the subjectivity of discretionary investing and the rigidity of quantitative investing, CFA Institute recently wrote. Recent developments in machine learning have created exciting possibilities to combine the two investment philosophies, the article said. It highlights an even more compelling application of AI, saying it is "now realistically possible to create an artificial replica of an actual investment manager, a machine that learns by example and develops its own investment style." Read more

Studying Buffett: Financial Analyst's Journal published a 2018 paper that analyzes the outperformance generated by Warren Buffett's Berkshire Hathaway. The introduction by AQR Capital notes that while every investor has an opinion on how Buffett has done, there hasn't been much empirical analysis to explain his performance. Buffett's returns appear to be "neither luck nor magic, but, rather, reward for leveraging cheap, safe, quality stocks." The study, which involved "decomposing Berkshires' portfolio into ownership in publicly traded stocks versus wholly-owned private companies," revealed that the publicly-traded shares were the stronger performers. Read more

Private Equity: CFA Institute recently wrote that even though most people in the investment world are consistently told that past performance is not indicative of future results, some claims regarding performance of private equity firms can be misleading. The article takes issue with the claim that the factors driving returns in public equity markets don't affect private equity returns. Private equity, it argues, is "just equity offered in a form that is relatively opaque, illiquid, highly levered, and has high fees and expenses." Read more

Bear Indicator: Goldman Sachs' bear market prediction metric is at 73 percent, the highest level since the late 1960s and early 1970s, according to CNBC. Such a high level has typically signaled zero-average return over the next 12 months and a big risk of a downturn. The indicator considers the unemployment rate, manufacturing data, core inflation, the yield curve and share valuations. Read more

Debt Overload: According to billionaire hedge fund manager Paul Tudor Jones, the world has too much debt, a situation that could lead to "trouble across markets and asset classes," CNBC recently reported. The Institute of International Finance said last year that worldwide debt has reached $247 trillion. Tudor said in November that we're probably in a global debt bubble, and the first signs of trouble will show up in the corporate bond market. Read more

Manager Review: McKinsey & Co.'s published its annual review of the North American asset management industry in November. In 2017, Institutional Investors noted, managers in the top quartile grew revenue 21% versus just 2% expansion for those in the bottom. The article reports that in the prior year, top managers grew revenue by 5% compared to fourth-quartile firms which showed shrinkage of 9%. Read more

Point72: During a recent talk, billionaire Steve Cohen said a bear market is coming within the next 18 months to two years, Fortune reported in a recent article. Cohen established Point72 Asset Management last year and says he was able to raise $5 billion fairly easily, noting that his goal is to build a "complete venture capital operation" including investments in artificial intelligence, machine learning, fintech and cyber security. Read more

Market Doubling: A bold call in November by Baron Capital had the stock market doubling in 10 years, Barron's reported. But how bold a call was it? The article contends that the S&P 500 would have to return just over 7% a year to accomplish such a feat, asserting, "But really, that's not much better than how stocks usually do." It cites data from Credit Suisse's Global Investment Returns Yearbook 2018 that shows U.S. stocks have returned 6.5% a year since 1900. Read more

Performance Update

Since our last newsletter, the S&P 500 returned 4.3%, while the Hot List returned 6.6%. So far in 2015, the portfolio has returned 5.6% vs. 3.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 182.4% vs. the S&P's 159.6% gain.

Latest Changes

The Hazards of Timing Factors

One of the first things investors learn is to buy low and sell high. It applies to simple stock investing and it's tempting to think it can be applied to factor investing, too. Cheap value stocks should, in theory, eventually rebound. So it makes sense to buy them up and wait it out. It equally makes sense to pare back exposure to factors that have had a long period of significant outperformance, like growth and momentum stocks. But this simple idea is easier said than done.

Even prominent and successful investors like Rob Arnott of Research Affiliates and Cliff Asness of AQR disagree on the topic.

Arnott examined the idea of factor timing in a paper in 2016 called "Timing 'Smart Beta' Strategies Of Course! Buy Low, Sell High." He looked at the best and worst performing factors at the time and compared them to a portfolio evenly weighted across all factors. Trend-chasing and contrarian portfolios had the three factors that either performed best or worse over the average of four historical periods. Meanwhile, the evenly weighted portfolio had all eight factors the portfolios followed. Comparing them, chasing the hot factor wasn't successful but being contrarian and buying the out of favor factor did generate excess return. Of course, it was also higher risk. The conclusion was that it's possible to time factors, but difficult.

Asness responded with his own paper, called "Contrarian Factor-Timing is Deceptively Difficult." In it, he says he showed that factor timing was more difficult than simple market timing. Long-short factors have more turnover than the market, making it harder to predict them longer term. And value factors are already influenced significantly by contrarian factors working against them. "It isn't at all obvious that one should value-time factors, at least not to any significant extent," he wrote.

Timing is still a subject of considerable debate among factor investors, so what is one to do if two of the great minds can't come to an agreement? It might be best to avoid it altogether. But if you insist, here are some rules of thumb that might help:

1. You will be early and your emotions will likely get the best of you.

Investing factors can be out of favor for an extremely long time. Just ask value investors. Timing the exact inflection point is next to impossible. Even during the last decade of underperformance, Value factor investors have to have been adding value stocks to their portfolio. It's hurt them, too, since growth has been the story. These investors will eventually be right, but the question is how many are willing to stick around until then? The excess returns you ultimately get may not overcome the underperformance you experienced while waiting for the day to arrive. It will take an iron will most people don't have.

2. Sin less than a little.

One of AQR's conclusions was that investors could "sin a little" when it comes to timing the market. Since factor timing is harder than actual market timing, it might make sense to sin a little less than that, which is to say to make smaller moves over time and accepting that you will be wrong until you are right. It requires resisting the temptation to go all in on a factor that is out of favor. Doing so is a sure way to discourage you from sticking with the decision.

3. Have a system

The best way to manage emotions in investing is to have a system from the start. A disciplined system can help you follow your plan without deviating. Momentum investors had to face a difficult decision in 2018 after a year of strong performance. Was the downturn a temporary blip or a shift? Failure to answer that question correctly could have cost investors all their gains. Discipline removes this risk.

Factor valuation spreads are one way to time factors. They measure the difference between the most and least expensive stocks using the same factor. Just remember to stay disciplined about it.

4. Understand that sometimes this time is different.

This is a treacherous idea for investors. It's either going to be a reversion to the mean or a fundamental and permanent shift to a new normal. Has the price/book factor ceased to function in a world dominated by technology and service companies? Some think it has. If the people who agree with this idea are correct, it makes no sense to try to time the price/book factor because you will just be adding exposure to something that no longer works. Often by the time a factor is discovered to have stopped working, it's too late for investors.

This isn't to discourage people from trying to time factors, just to serve as a caution that it is extremely difficult to do so and a strategy needs to be well-thought out and executed with discipline. We talk a lot at Validea about removing emotion and human bias from investing, and factor timing is certainly no exception. That is why our models and stock screening tools help put an objective filter over a strategy, helping investors resist the temptation to chase the hot trend or fall down the rabbit hole of a losing position. But unless you have an iron will and the strength to be wrong for a significant period of time, there may be better places to find alpha.

Newcomers to the Hot List

Acuity Brands, Inc. (AYI) - This maker of commercial and residential lighting fixtures scores highly on the models tracking the styles of Peter Lynch and Kenneth Fisher

Innoviva, Inc. (INVA) - This biopharmaceutical company scores highly on the models tracking Joel Greenblatt, the Validea momentum portfolio and a Motley Fool small cap growth portfolio.

Janus Henderson Group (JHG) - This active asset management firm scores highly on the models tracking the styles of Peter Lynch, Benjamin Graham and John Neff.

ProPetro Holding Corp. (PUMP) - This oilfield services company scores well on the model tracking the style of Joel Greenblatt.

Toll Brothers, Inc. (TOL) - This luxury residential homebuilder scores well on the models tracking the styles of Peter Lynch, Martin Zweig and John Neff.

News on Hot List Stocks

ProPetro completed the acquisition of pressure pumping assets from Pioneer Natural Resources Co. for $400 million in cash and stock.

Acutiy's first quarter sales rose to $933 million but adjusted operating profit fell 1%, to $134 million.

Guru Analysis

Watch List

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

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