Economy & Markets

While the S&P 500 is up a solid 11% this year, new data could indicate some warning signs. Federal Reserve officials focused in their most recent meeting on how their efforts to cut the central bank's balance sheet are affecting risk assets like stocks and bonds. The latest meeting minutes reveal they may end the reduction program this year, earlier than expected. That's a good sign for investors. But other signs show softening in demand for U.S.-made goods and weakening consumer sentiment. The Conference Board's leading economic index fell for the second straight month in January, the first month-to-month pullback in three years. Stocks could be taking a pause after their rally this year, as concerns fade away about whether the U.S. and China would be able to come to an agreement on trade The S&P 500 is trading at a current multiple of 20, led by industrials, energy and information technology. Utilities, health care and consumer staples lag this year. The Dow Jones Industrial Average trades at a multiple of 18.

Some numbers to watch :

1. The Commerce Department said core U.S. durable capital goods orders fell in December, the fourth decline since August.

2. IHS Markit said the U.S. manufacturing purchasing managers' index fell to 53.7 in February, a 17-month low. Survey respondents cited a soft patch in demand.

3. New numbers suggest the labor market is slowing. While jobless claims fell last week, the four-week moving average is at a one-year high, Reuters reports.

4. U.S. existing home sales dropped 1.2% in January, the third consecutive month of declining sales.

5. TransUnion reports that unsecured personal loans hit an all-time high last year of $138 billion, and fintech startups are leading the way.

Recommended Reading

Indexing is popular, but the major indices like the S&P 500 are market-cap weighted and that can have some downsides, Morningstar notes. In certain markets or strategies it can compromise diversification and intended factor exposure because it emphasizes stocks that have the richest valuations. In some markets, these stocks become so large that they skew the overall index. And it underweights smaller, higher quality stocks with potentially better returns. The article suggests value investors use strategies that weight stocks differently. For more on this read here , and see links below for articles and blog posts you might have missed.

Value Rebound: Value bested growth by more than 2 percentage points in the fourth quarter, according to Financial Times. Weaker earnings growth for the tech sector and broader fragility in markets may be changing the game for stock pickers, says Brent Fredberg, the director of investments at Brandes Investment Partners. Read more

Bearish Shift: Quant investing shop AlphaSimplex Group did some research that found trend-following strategies have shifted to bearish from bullish to a degree not seen in a decade. The shift happened, according to the WSJ, amidst weak economic data and geopolitical uncertainty. Read more

Growth Overseas: Forecasts show higher returns for non-U.S. stocks, especially emerging markets, over the next decade, according to Morningstar. And starting yields on intermediate term bonds, which have been a good predictor of returns, suggest bonds will give U.S. equities a serious challenge. Read more

Bullish Signs: Pessimism by stock market timers is a bullish sign for contrarians, according to Mark Hulbert in a December MarketWatch column. As of then, the average recommended equity exposure measured by his sentiment index was -15.6%, one of the lowest ever. The last time it was that low was in Feb. 2016, at the bottom of a correction that began the year before. Read more

Reputation Risk: A good reputation, strong competitive advantage and popular brand make for a stock that has bad investment prospects, according to researchers at CFA Institute and Morningstar. The price of these stocks already reflects these attributes. The stocks with the worst reputation rankings outperform those with higher rankings. Read more

Bond Warning: DoubleLine's Jeffrey Gundlach calls U.S. corporate debt "horrific" and says recession indicators like junk bond spreads, consumer expectations and homebuilder confidence are flashing yellow, according to Bloomberg. He talked about these trends in his annual "Just Markets" webcast in January. Read more

Emerging Outlook: Emerging markets stocks are not as risky as people think they are, according to a recent article in Fortune that looks at the optimistic outlooks by Jeremy Grantham, Mark Mobius and Rob Arnott. Even when EM economies do slow down, they still grow faster than their mature economy counterparts. Chris Brightman of Research Affiliates says EM should return 10% a year over the next decade compared to the 3.2% annual growth seen for U.S. stocks. Read more

Stock Gains: Blackstone's Byron Wein sees a 15% gain in the S&P 500 this year. He told CNBC that growth stocks will continue to provide leadership in the market and that the economic expansion would continue this year because of consumer and government spending despite only modest gains in housing. Read more

Canadian Buffett: Bloomberg recently profiled Jim Pattison, the Canadian billionaire often compared to Warren Buffett. Pattison built an empire that includes supermarkets, fisheries, lumber and packaging as well as Ripley Entertainment. He said he still sees a lot of opportunities in the world. Read more

Repeating Mistakes: Financial advisors and investors continue to make the same mistakes in the process of hiring and firing portfolio managers, according to CFA Institute. People choosing managers focus too much on performance or outcomes and not enough on process. Read more

Timing Factors: Morningstar discussed how new research shows it's possible to successfully time factors such as value, momentum and quality. It cites a recent paper by BlackRock pointing to the four factor timing-signals that work well, but also adds its own dose of skepticism to the findings. Read more

Miller's Lessons: Bill Miller, who now manages $2 billion at his new firm Miller Value Partners, recently told Institutional Investor about the lessons he learned from the financial crisis and gives his perspective on the popularity of passive investing. Read more

AI Skeptic: Barron's recently interviewed David Harding, the founder of $27 billion Winton Capital who uses high-powered computers to pick up trading signals and patterns. He says artificial intelligence is over-hyped. He refutes the idea that you can feed a lot of data into an advanced computer model and then have it tell you what's going to happen. Read more

Yield Focus: Investors should focus on the difference between the earnings yield on stocks and the yield on cash, says Nir Kaisar in a recent Bloomberg column. When the yield on stocks is lower than the cash yield, it's a sign of trouble ahead for stocks. Read more

News on Hot List Stocks

Essent Group reported fourth-quarter net income of $128.5 million, or $1.31 a share, beating expectations.

CBRE is trying to get into the shared workspace business dominated by WeWork, by helping landlords create their own flex-space companies, WSJ reported.

TD Ameritrade shareholders approved the nomination of four directors and the company's advisory on executive pay.

Apple's new credit card in partnership with Goldman Sachs will run on the Mastercard platform.

Monolithic Power Systems reported fourth-quarter profit of 99 cents a share, meeting expectations on revenue of $153.5 million.

Performance Update

Since our last newsletter, the S&P 500 returned 2.5%, while the Hot List returned 2.4%. So far in 2019, the portfolio has returned 12.3% vs. 10.7% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 200.3% vs. the S&P's 177.4% gain.

Where Has All the Alpha Gone?

It isn't easy to beat the market. Over the long term only a few investors have been able to outpace it, consistently producing market-beating gains. But that hasn't deterred stock pickers from trying to generate alpha. They arm themselves with sophisticated models, hunting for overlooked opportunities and hoping the crowd doesn't catch on. But this becomes a self-fulfilling cycle. As the skill of managers rise and the tools improve, it becomes harder and harder to distinguish the talented from the rest of the crowd.

Michael Mauboussin wrote about this six years ago when he was at Credit Suisse, publishing an article called "Alpha and the Paradox of Skill." He set out to show how excess returns get harder to achieve as investors become more skillful. He called investing a zero-sum game in which one investor's outperformance has to be matched by another's underperformance. Epsilon Theory's Ben Hunt puts it another way: Alpha = private information. (He recently tweeted this, in fact).

What Hunt says makes sense. Having the best information and having an exclusive on it gives an investor an edge. And if he's right, it has profound implications for factor investing and active management.

It's important to note that there's a difference between alpha and outperformance. Alpha is the excess return that can't be explained by the risk you took. When the only standard was beta, calculating this difference was relatively easy. Alpha was the amount of excess return you realized above and beyond the return required given the risk of your portfolio. But then multifactor models came in to play and complicated things. Beta is not the sole measure of risk. Value and size and profitability also come into consideration. A value investor can't just get alpha from standard exposure to value. The investor needs to produce a return beyond the return that would be predicted by the exposure to value. It makes alpha harder to find.

So back to Ben Hunt's view. Does generating alpha mean you need access to information no one else has? There are three ways to generate edge in investing.

1. Having information others don't have. The information edge seems kind of obvious. But in a world where information flows freely and public companies have strict disclosure requirements, it's much harder to get a hold of juicy nuggets of information. And big data isn't going to help bring alpha back. If anything, it is removing the information edge entirely.

2. Having the ability to evaluate the information better or differently. O'Shaughnessy Asset Management points out that investing using standard factors is settled territory at this point. An investor can easily get beta exposure to something like value or quality through inexpensive ETFs An active manager who uses factors needs to add value by producing alpha beyond the standard returns of the factor itself. A select group of managers has been able to pull this off using an analytical edge. But developing this analytical edge is difficult and getting harder to do over time.

3. Having the ability to control your own behavior. An investor who can stay the course during periods of losses or underperformance when others can't has the ability to boost returns relative to most others. Some call this "behavioral alpha." But while behavior helps boost returns, it isn't alpha. For example, the ability to stick with a strategy regardless of its volatility and tracking error would allow an investor to use a more focused value strategy, which would result in more exposure to the value factor, and likely a higher return. But that wouldn't outperform the value factor itself.

Of course, a lot of people would say it doesn't really pay to focus on such details. The point of investing is to make money grow over time and reach whatever goals were set for that money. Generating alpha may matter more for bragging rights among professional managers than it is relevant to ordinary investors in the grand scheme of things. But the point is that the market is hard to beat. Having a thoughtful process that takes the emotion and guesswork out of investing is probably the best approach. At Validea we have spent a lot of time setting up models that made this systemic approach to investing easier. If you're going to attempt to generate alpha for yourself, you're going to need to have a very high conviction that you have an edge and that you have the ability to stick with your process through thick and thin. For investors who can do this, alpha is possible, even if it's not based on non-public information.

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