Inside The Stock Market ...trends, cross-currents, and outlook
Last spring and summer, we were incorrectly skeptical that a new bull had been born only five weeks after the death of oldest bull ever. But be careful with labels. Just as the “bear market” mindset caused us to overplay our hand last spring, equity bulls should not assume the current bull will look anything like the decade-long affairs we’ve seen twice in the last 30 years.
Cap-weighted valuations for the S&P 500 and S&P Industrials are homing in on the all-time records seen in the first quarter of 2000. We’ll confess that after those valuations collapsed in the years that followed, we thought we’d never see them again in our lifetime—let alone a mere generation later.
In recent months, we’ve highlighted some reasons to buy or add to Emerging Market equities, and at year-end received a formal endorsement from our monthly Emerging Market Allocation Model. The signal triggered after a 30-month period in which the model recommended the relative “safety” of the S&P 500—in retrospect, a good call.
The AANA Portfolio could be viewed as representing one extreme of the asset allocation continuum—in which no knowledge of comparative asset valuations or economic conditions is assumed (or, at least, imparted). At the opposite pole would be the clairvoyant speculator who puts all of his or her eggs into one basket and holds that basket for the entire year.
In the extreme case where one possesses no other information beyond last year’s total returns, the best single-asset strategy has been to buy the second-best performer (the “Bridesmaid”) and hold it for the next twelve months in hopes that the prior year’s momentum will carry it through. That approach has beaten the S&P 500 by 3.7% annualized over the past 48 years.
With last year’s Bridesmaid (REITs) having laid an egg, the long-term “alpha” of the Bridesmaid portfolio narrowed to +3.7% from a bit over +5% (annualized) when we first published this study more than a decade ago.
Our work on the annual “momentum effect” dates back 15 years, and was originally based on equity sectors rather than asset classes. The hypothetical approach is to entirely dispense macroeconomic trends, sector fundamentals, and valuations, and base the allocation decision exclusively on momentum.
We’ve worried over the last several years whether momentum and other “alpha” factors have become exploited to the point of diminishing returns. It’s an arms race out there...
Financials was the “cheapest sector” in each of the last three years, and its significant underperformance versus the S&P 500 has shaved the historical “alpha” from this strategy. Still, those souls who’ve had the stomach to own the Low P/E sector each year have beaten the S&P 500 by 2.9% per annum since 1991.
In April 2018, armed with a large number of ETFs and long-enough historical data, we applied our back-testing methodology for individual stocks to the universe of ETFs to determine if the same (or some) of those components could useful for assessing ETF performance prospects. One of the factors we reviewed was fund flow (adjusted by AUM), which revealed that those ETFs experiencing the largest asset inflows proceeded to significantly underperform.
For almost nine months, an historic Fed liquidity flood has washed away any economic, valuation, technical, or “sentimental” stock market challenges. Nonetheless, each economic disappointment brings hope this flood will intensify. Those hopes aren’t irrational, because when it comes to any measure of liquidity, rate of change is more important than level.