Market rents are typically fixed in size. When a strategy to exploit a particular market inefficiency gets too big, returns to the rent disappear, or even go negative prospectively, even if they appear exceedingly productive retrospectively.
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If you have read me for any decent amount of time, you know I am big on economic and financial cycles, and how they can’t be eliminated. There are two groups that think the cycles can be eliminated:
- Politicians and Central Bankers who think they can create permanent prosperity, when all they really create is an increase in overall debt.
- Efficient market theorists who think there are no strategies that beat the market.
It is the second group that I am dealing with this evening. Market strategies trend. If we have had outperformance from value investing this year, the odds are good that we will have it next year, unless it has gone on for too many years (5+).
Ideas in investing tend to streak, get overinvested, then die. This is one reason why I don’t believe articles about the death of various investment concepts. We need to think about investment ecologically. There are no permanently valid investment factors to beat the market. There are many investment factors that beat the market over time, but not while many are pursuing them. Imitation drives returns, and then over-imitation kills them.
That means we should be wary when a strategy has been working too well for too long. It also means we should be skeptical when any strategy with a strong thesis behind it is declared “dead.” That may be the very time to consider it, or maybe wait a year or two. Many strategies are forgotten; after a time of failure it is time to remember them.
Part of this stems from the biases of institutional investors. They think that their winnowing down of the investable universe through screening will always produce a good crop of candidates in which to invest. But that’s not true. Talented investors think more broadly, and are willing to consider investments that don’t fit within common screens.
The thing is: strategies go in cycles. They are born at a time when no one loves them. They gain currency from the good returns of those who adopt them, leading to a frenzy where many adopt the strategy, and returns are great, but now companies that fit the strategy are overvalued. The process goes into the reverse gear where the strategy is garbage, until enough parties abandon it and the prices of stocks that would be a part of the strategy are attractive.
So when you hear:
- Value is dead
- Growth is dead
- Large caps are dead
- Small caps are dead (rare)
- Momentum is dead
- Low volatility is dead.
- Quality is dead.
- Low Quality is dead.
- XXX industry or sector is dead.
Be skeptical, and begin edging into companies that you like in the “doomed” strategy. Make sure they have strong balance sheets and competitive positions. That will protect you if the trend persists.
One more note: this doesn’t work in reverse. A strategy that has been working for a little while will likely streak. Resist the trend when it is old, not when it is young.
Finally, remember: there are only tendencies, not laws: markets exist to surprise you. There are theories that work in the market over time, but they do not work year after year, the results come in lumps, unlike the projections of the financial planners.
And I close by saying to all of my readers — is this not how the market works? There is momentum, but it sometimes fails dramatically. Ideas streak, and then collapse far faster. I say be aware of what has been rewarded and what has not. Sell stuff that has been rewarded too long, and that which has been recently trashed. Buy the stuff that has come into favor, and strong companies that have been unduly trashed.
By David Merkel, CFA of Aleph Blog
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