Think Half of a Cycle Ahead

Think Half of a Cycle Ahead


Photo Credit: Robert Tuck

This Top Value Hedge Fund Is Killing It This Year So Far

Stone House Capital PartnersStone House Capital Partners returned 4.1% for September, bringing its year-to-date return to 72% net. The S&P 500 is up 14.3% for the first nine months of the year. Q3 2021 hedge fund letters, conferences and more Stone House follows a value-based, long-long term and concentrated investment approach focusing on companies rather than the market Read More

|| Of course, in half a cycle here, the moon will look the same


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Financial markets are trendy and noisy in the short-run, sensible in the long-run, and perverse in the intermediate-term.

What do I mean?

Something like this: short-run movements are news-driven, and driven by people trying to catch up with the latest data. Many people imitate the behavior of others, and over the intermediate-term, some stock prices get out of whack. Some subset of industries, factors, and/or companies gets out of alignment, and are mispriced. In the long run, those pricing errors get corrected, but it takes years to get there.

Here's an example. to make this tangible and understandable. As a factor, value has been bad for eight years or so, and as evidence I quote Rob Arnott, from his article entitled, ‘How Can “Smart Beta” Go Horribly Wrong?'

The value effect was first identified in the late 1970s, notably by Basu (1977), in the aftermath of the Nifty Fifty bubble, a period when value stocks were becoming increasingly expensive, priced at an ever-skinnier discount relative to growth stocks. More recently, for the past eight years, value investing has been a disaster with the Russell 1000 Value Index underperforming the S&P 500 by 1.6% a year, and the Fama–French value factor in large-cap stocks returning ?4.8% annually over the same period. But, the value effect is far from dead! In fact, it's in its cheapest decile in history.

And then later he says:

How many practitioners who rely on the value factor take the time to gauge whether the factor is expensive or cheap relative to historical norms? If they took the time to do so today, they would find value is currently cheaper than at any time other than the height of the Nifty Fifty (1972–73), the tech bubble (1998–2003), and the global financial crisis (2008–09).

The underlining is mine, to give emphasis. Now I would like to quote from a very old article of mine, The Fundamentals of Market Tops that was originally published at back in 2004:

You'll know a market top is probably coming when:

a) The shorts already have been killed. You don't hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

Point (b) is what I want to highlight… not that we have had many value managers forced into retirement recently, but value funds of all kinds have been losing clients. It's like being fired fractionally, a sliver at a time, but it adds up to a lot.

Combine that with Arnott's insight that the valuations of value stocks are at exceptionally low levels – this gives me some hope that we are in the seventh inning or later in this market cycle regarding value investing.

Going Back a Step

Value isn't the only cheap area presently — European stocks and emerging market stocks look cheap as well. When areas of the market with bad relative performance have a lot of people giving up on them to pursue recently successful strategies, that helps to put in the bottom on the underperformers, and the top on the outperformers.

You can't tell exactly when the process will end, but those jumping from one strategy to another, chasing performance, will just add a new set of losses to the old ones. The trick is to try to anticipate when the cycle will turn for a given market strategy, factor or industry. No one can do it perfectly, but it makes sense to act when relative valuations are in your favor.

Minimally, those that stick with a valid strategy through thick and thin can benefit from the strategy over the long-term… and that takes some courage, because there are times when your strategy will be out of favor. That's what I do with value investing.

Maximally, you would sell a strategy that you were invested in that was topping out in relative terms to buy a strategy that has been trashed for a while, and might be ready to outperform. That's even more difficult than sticking with one strategy through thick and thin. Everyone wants to buy a past winner, and nobody wants to buy a past loser. but that is what would offer large returns if the timing could be right. Another way of phrasing it, is to always look half a cycle ahead, to where a strategy will be when the excesses correct, or as is more likely, overcorrect, and take the appropriate action now.

Doing that is beyond me. I'm just grateful that the period of relative underperformance of value may be nearing its end.

Updated on

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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