Wolfe Trahan Published Research » Quantitative Analysis

Junk Rally Or Return To Cyclicality?

Wolfe Trahan — Thu, 02 Feb 2012 13:34:18 +0000

Stocks are up 21% since the October bottom in the market. LEIs have significantly improved and look set to maintain their positive trajectory. All is well in the world … right?!? In the minds of many investors, issues such as the European crisis, housing, and employment continue to take credence from the improvement in the stock market. As such, the lack of faith in the return of cyclicality has led many to dust off the “junk”-rally branding. We have recently begun to hear in the media and from investors that “junk” is outperforming and “quality” is underperforming. Today, we take a look at whether or not this is true (it’s not!) and how investors can properly position their portfolios for a rise in leading indicators.

In our minds, the run-up in equities over the past several months isn’t so much of a “junk” rally as it is a return to cyclicality. Understanding why investors and the media label such rallies as “junk” is a hard question to answer. It may be that we are victims of our environment and, outside of the market strength during QE2, we have been in a stagnant market for the better part of two years. Roll the clock back even more and you have the financial crisis where defensive positioning was the only way to keep your head above water. Are we just being slow to adapt?

In today’s report we delve into answering some of these questions and respond to the rebuttals surrounding the recovery in equities. Beyond just answering a few questions, we look at how this rally and the return to cyclically have played out on the sector and factor level. As any reader of our work knows, we believe the turn in the market and the associated shifts in leadership all come down to changes in the business cycle and the path of economic prospects (LEIs).

10 Things That Could Sabotage Performance Despite A Good Macro Call

Wolfe Trahan — Thu, 12 Jan 2012 13:19:40 +0000

Over the past few years, the average investor has likely spent more time researching macro trends than they have in the past. As we like to point out in our research, getting the big picture (i.e., business cycle) call right is the first, and most important step to increasing the odds of outperformance in a given year. 2011 was no exception … with all of the structural headwinds that crowded the media airwaves, it was sometimes difficult for investors to see the forest for the trees (i.e., the major trend of the cycle). In our Portfolio Strategy research, we’ve endeavored to demonstrate a set of forward-looking tools that can help investors get ahead of the business cycle, even in the current Era of Uncertainty. These tools told us to get more bullish in the 4^th quarter of 2011 and continue to sing the same tune in 2012.

While getting the macro call right puts the odds of outperformance highly in one’s favor, there are still mistakes that can unfortunately be made in other areas of the investment process. Over the years, many lessons of stock selection have been passed down both in academia (e.g., Graham & Dodd) and in practice (e.g., from one’s boss). On balance, most investors follow a similar set of guidelines that set the framework for their stock selection process. Compounding this issue of “group think” is the fact that the majority of research providers solely focus on buy ideas, also using a similar framework. With all of these “best practices” that have been passed down from investor to investor, so too have a lot of bad habits. This brings us to the main idea of this report, which is knowing what not to do is often more important than knowing what to do. The following report challenges a set of common principles and practices of stock selection that many investors believe to be true.

A Lighthearted Look At Some Market Folklore

Wolfe Trahan — Thu, 22 Dec 2011 12:43:50 +0000

As we head into the long holiday weekend, investor’s minds, and shortly their bodies, are elsewhere. We always like to take this time of year to pause from our usual research grind and publish a report a bit on the lighter side. As many of our regular readers know, this is a semiannual tradition for us around the 4th of July and December 31st. In the past, we’ve written on classic Wall Street folklore such as the “Nifty 50″, “Dogs of the Dow” and even the “Hershey Bar Index”. Today’s report updates some other classics for year-end such as the “Super Bowl Indicator” and our favorite, the Dart Board stock strategy (which really underperformed in 2011). Enjoy this light read over the long weekend. Happy Holidays.

Wolfe Trahan Quantitative Research: 2011 Factor Scorecard

Wolfe Trahan — Thu, 15 Dec 2011 13:06:11 +0000

It is fairly clear that by mid-December most investors are already thinking beyond the holiday season and into the upcoming year. We like to take this time to wrap up our thoughts on the year, and highlight some of the key trends that helped to define 2011. While stocks remain well below the mid-year highs, some strength has returned to the market and the economy (Eurozone PMIs are at a 3-month high). The market volatility this year was not the only monkey on the back of investors as factor efficacy “appeared” to diminish in the eyes of many investors. While macro forces were a driving force behind many of investors’ woes, the perception of factor performance boils down to elevated stock correlations. As we have written about at length (see reports 12/2/10 & 9/20/11), this type of market backdrop requires investors to revisit classic portfolio construction and incorporate some modern ideas.

While correlations were a major theme for investors in 2011 and a major ingredient in the portfolio-manager recipe, we also introduced our White Box stock selection model this year (Introducing The Wolfe Trahan White Box, 3/29/11). The model is a culmination of the best work we have done over the past few years. It classifies our best stock screens into seven categories (the seven pillars of investing). The framework we present is one that helps investors know when to emphasize one type of factor over another around the business cycle and covers the entire investment process including a road map for adjustments based on the correlation backdrop. Usually, we like to look forward in our work (as opposed to backwards), but as the year winds down, we feel it is always important to reflect on what has shaped the market and why. We’ll be back in January with new and fresh ideas, but until then Happy Holidays!

Leadership In Offensive Factors Poised To Continue

Wolfe Trahan — Thu, 08 Dec 2011 11:54:46 +0000

This year has been an extremely challenging year for most investors as “New Normal” economic and market dynamics have altered the rules of investing. Many have come to terms with the fact that an investment process solely rooted in buying so-called “good” companies isn’t enough to outperform anymore; it is quite evident that one must include a macro view in his/her framework to stay ahead of the pack. That said, one’s macro view must be forward-looking in nature as reacting to the dreadful headlines coming out of Europe isn’t a disciplined approach to investing. As traditional policy measures have broken down in recent years, we’ve been able to maintain a forward-looking approach to macro by observing how the economy/market responds to past inflationary pressures (“inflation is the new Fed Funds rate”). Today, easing is in the pipeline in the form of lower inflation and global central bank easing. These are the tailwinds that will likely support higher LEIs and higher equity returns ahead.

Throughout the year, high intra-market correlations have been another factor making stock-selection difficult. As of the end of last month, the 60-day correlation of stocks in the S&P 500 rose to an all-time high (>80%). In addition to changing the size of one’s portfolio (see our 9/20/11 Quantitative Research report), investors can improve their odds of outperformance by knowing which business cycle phase we are in. As we illustrate on the cover charts, the disparity of returns across business cycle portfolios has been tremendous in 2011. In other words, having a dynamic (not static) investment approach would have helped a lot this year. Today, we believe that we will be in the Late-Expansion phase of the cycle in the months ahead … this argues for more cyclicality in stock selection (and less defense).

Practical Offensive & Defensive Strategies For Stock Pickers

Wolfe Trahan — Thu, 03 Nov 2011 12:26:25 +0000

As we’ve taken our bullish thesis to the road, we received the usual (and expected) pushback as well as the question, “what should I be buying?” Our response to this question throughout 2011 has repeatedly been “stability over cyclicality” … Going bullish simply suggests a flip of that statement. Importantly, taking on more cyclicality is NOT synonymous with buying the lowest-quality companies (i.e, junk). It is commonplace for investors to mislabel a beta rally “a junk rally” (beta and low quality are NOT necessarily one and the same). In this report, we illustrate why investors should embrace cyclicality in the months ahead, and importantly, maintain a persistent focus on high-quality fundamentals.

Today, investors face a unique combination of deteriorating earnings quality and an economic outlook that is set to improve, albeit cyclically. These conditions suggest two things: 1) there are potentially more accounting shenanigans taking place today (some valuation metrics become suspect); and 2) fewer stocks are likely to outperform the benchmark. This means that the job of a stock picker (uncovering outperformers) is likely to become more difficult and potentially carry more risk. In these conditions, investors should remain focused on high-quality fundamentals and high-quality screening factors.

In practice, our White Box framework is built on the foundation of first narrowing the universe down to attractively valued, high-quality companies. We then layer on risk parameters to increase or decrease the portfolio’s exposure to cyclicality. Regardless of the cycle, we are always emphasizing strong fundamental factors (e.g, cash flow). We would never own “low quality or junk” regardless of the macro outlook … Nor should you.

Transitioning Your Portfolio For Better Days Ahead

Wolfe Trahan — Thu, 20 Oct 2011 12:15:56 +0000

Today, the influence of the business cycle on equity returns is as important as it’s ever been. Understanding and successfully being able to navigate the ebb and flow of the economy will be paramount in the New Normal. Today, we face structural headwinds that have made cycles shorter and move volatile. Gone are the days of the Great Moderation and long-duration expansionary periods that were extended by credit, lower inflation and accommodative Fed Policy. Until the U.S. solves its housing, consumer and fiscal-indebtedness problems … and our neighbors across the pond implement a realistic plan that leads to a long-term solution, the investment outlook is likely to be fast and furious, filled with shorter cycles. We’re not holding our breath; these problems are likely to be here for several years. This suggests that portfolio managers will have to be more active and that buy-and-hold strategies may experience more difficulties as investment values remain highly cyclical.

In Monday’s Portfolio Strategy report, we made a material change in our view of the business cycle and financial markets. After having a bearish bias for most of 2011, we’ve reset our risk posture towards financial markets to neutral in the short-term as we expect a tactical improvement in the economy over the next couple of quarters. This doesn’t change our long-term views of sub-par growth, but our indicators are currently telling us that growth should find support in the months ahead. That said, timing is everything, and none of our series tell us the precise day/week/month when the risk posture of the market will turn for good. Today’s report demonstrates how we would transition our portfolio for better days ahead, still under the framework of our White Box investment philosophy. Time to transition!

Good To Great

Wolfe Trahan — Thu, 06 Oct 2011 12:21:11 +0000

In the bestselling book Good To Great, author Jim Collins poses the question, “Can a good company become a great company and if so, how?” After digging through thousands of companies that have “made it”, he concluded that it is possible and that there are many roads that lead to success. Notably, some of these common roads that he found challenged conventional wisdom of how corporate success is measured. Collins et al. concluded that becoming a great company did not require a high-status CEO or the latest innovation, but instead a “corporate culture that rigorously found and promoted disciplined people to think and act in a disciplined manner.” That said, there is no silver bullet, as two of the “good to great” companies Collins studied have since collapsed (Circuit City, Fannie Mae).

So why is this relevant to portfolio managers? Just like Collins looked for common characteristics of companies that went from good to great, investors can do the same. Earlier this year, we introduced the White Box model to do just that. By identifying the best of breed factors across the seven pillars of investing, we built a framework to consistently select future outperformers in any market environment. In this report we pose the question, “Can a good investment strategy become a great investment strategy and if so, how?” We’ve taken the most popular “good” investment strategies (e.g., Value, GARP, etc.) and combined them with our disciplined business-cycle framework to make them “great.” While there is no silver bullet in investing, our White Box model provides a potent weapon to investors.

Outperforming In A Highly-Correlated Market Environment

Wolfe Trahan — Tue, 20 Sep 2011 12:08:00 +0000

The job of stock pickers has become more difficult over the past decade as macro (i.e., bubbles, busts and bailouts) has had an above-average influence on security returns. Elevated correlations across and within markets has become part of the New Normal that we discussed in our recent Portfolio Strategy conference call. In recent weeks, you’ve likely come across a news article, blog or research report that highlighted the near-record correlations within the equity market. We’ve come across many of these and note that, outside of recognizing high correlations, none of these articles provided solutions beyond the classic “be defensive” when volatility rises. In a December 2010 report, we discussed how portfolio managers can better navigate a period of elevated correlations while maintaining the efficacy of stock selection strategies (e.g., low P/E) by increasing the number of holdings in the portfolio. This report stirred up quite a bit of pushback with clients as many argued that under a highly correlated market, you should own fewer stocks (a common misconception). As we revisit this concept today, in a period of ultra-high correlations, the evidence is clear: in highly correlated environments, own more stocks!

The Lost Chapter On Valuation

Wolfe Trahan — Thu, 08 Sep 2011 12:44:51 +0000

For several months now, investors have been drooling over historically-low valuation levels. Buying the market on the back of a valuation call has been a painful experience in 2011 as what was perceived as a good deal six months ago has now become a steal. The good news for those that have held out and have the willpower to remain patient a little longer is that we think we’ll find better deals ahead. The odds are that leading indicators will continue to decelerate into year-end and we’ll see a “December to remember” sales event that would merit a TV commercial. Falling knives are painful to catch so anybody that says stocks are cheap better understand that they are indirectly making a call that leading economic indicators have bottomed. The charts below highlight major inflection points in valuation over the past decade and demonstrate how multiples changed course only as leading indicators peaked/troughed. Thus, stocks are only cheap today if LEIs are bottoming. If ISM falls to <45, today’s valuations will likely look expensive in hindsight. Valuation bulls will eventually be proven right … when LEIs begin to rise.

You can’t get through your inbox these days without coming across a handful of analyst upgrades that are rooted in valuation. The worst ones are those where the story hasn’t changed, fundamentals continue to weaken, but because of low valuation, it becomes a buy. That is pretty much the story right now for the S&P 500. At the stock level, valuation analysis can be a very powerful tool when used correctly (cross-sectional versus peer group), but can hurt you if used improperly (time-series versus itself). In this report we hope to shed light on the fact that most of the sell-side looks at valuation incorrectly and steers investors into potential value traps. We look forward to your feedback.