Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha Apr 19, 2021 1:11:27 PM 13 min read CIO Outlook

CIO Outlook: Q1 2021

There are two types of information that impact stock prices. The first is the clear and easily interpreted information that comes from the company financial statements. The other is the vague and ambiguous that, while relevant, is subject to different interpretations by different investors. Sometimes this second type is dominant and much of the resulting stock price is not supported by the known, but rather the unknown.

In his 2004 bestseller The Wisdom of Crowds, James Surowiecki famously provides evidence that when acting independently and in their own self-interest, the actions of individual members of a crowd result in an efficient outcome. Following this logic, if investors act independently in their pursuit of excess returns, the market will be efficient. Of course, the title of Surowiecki’s book is a nod to the classic tome by Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds (emphasis mine). What happens when the individuals in a crowd behave systematically similarly, not independently?

Look no further than the past year for the answer to that question. There are plenty of reasons to explain why the market has done well: fiscal stimulus, monetary stimulus, the realization that the pandemic didn’t have the economic impact many feared, to name a few. But certain individual stocks are clearly being impacted by the madness of crowds. We have seen this in huge mega-cap stocks and we have seen it among stocks facing bankruptcy. When crowds form, and humans, being social beings, begin letting each other influence their decision making, bubbles often form.

I am not here to tell you the market is in a bubble. Too much ink has been spilled over the last decade among pundits trying to call the top, who have largely all been wrong. However, there are, and always will be, bubbles in individual stocks. These are the stocks with prices that have been impacted by investors interpreting vague and ambiguous information in a systematically incorrect way. That is, the herd speaks louder than the individual. In such a situation, even Surowiecki concedes a breakdown in price efficiency.

Today’s environment is replete with information that is relevant to stock prices, but vague enough or ambiguous enough to allow investors to interpret it incorrectly. Consider the turbulent stock of Tesla, soaring through most of 2020 before its recent 30% drop. While the company might be strong and promising, the behavior around the stock price could be a problem. A group of investors systematically over- or underconfident in a company can send the stock rocketing to record valuations or careening downward. The lesson is simple: When vague or ambiguous information abounds, prices will behave wildly.

The solution to this problem is to avoid the madness. Avoid the vague and ambiguous information. This is our goal at New Age Alpha and the first quarter of 2021 has provided ample opportunity to do so. We believe our U.S. Large-Cap Leading 50 Index offers evidence of this. The Index is part of our index family and employs our rules-based, proprietary methodology to select 50 stocks that we believe have the least vague and ambiguous information impacting the stock price. In the first quarter of 2021, the Index outperformed the S&P 500® Index by 211 basis points. Additional performance information can be found below:

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LOOKING AHEAD

As we begin the second quarter of 2021 and, likely, embark on “Reopening,” the very nature of risk is worth pondering. When discussing risk, we can’t help but notice that—more often than not—it’s the unknown or unanticipated risks that pose the greatest risk. In retrospect, such risks may seem obvious. But in the heat of the moment, they were unanticipated or unappreciated by many:

  • By the end of 2019, inflated valuations and the trade war with China were the market’s biggest concern. Yet it was a hitherto unheard-of virus that shut down the global economy in 2020.
  • In 1998, the market suffered a correction yet, thereafter, continued to push even higher. Only in 2000, after the historic merger of a “New Economy,” and an “Old Economy,” company, did everyone realize that dot.com companies (and their valuations) still operate in the real world.

So far in 2021 the focus has surrounded the steep climb of yields as measured by the ten-year Treasury and the risk this may create for valuations. Surowiecki, however, may have something to say about investor’s ability to correctly interpret such expectations. Particularly when, historically, we rarely see the most common fear come to fruition as expected. More likely it’s a variant or a slightly different tipping point that causes upheaval in an unforeseen way. And the reason risk rarely works in such a linear fashion is because it originates in human behavior. At New Age Alpha, we accept this and make it work to our advantage. We don’t attempt to predict the future but, instead, only focus on the known information. So, as examples, we’re also currently hearing concerns about an uptick in inflation or the continued chorus of valuation worries. Yet, has anyone considered:

  • The psychological impact of renewed shutdowns should the vaccines fail against virus mutations?
  • A repo market computational / SWIFT failure that the Fed cannot backstop?
  • Potential for geopolitical strife and Reopening, in unison, shooting oil prices sky high?

The list goes on. With strong tailwinds from both Reopening and additional stimulus, it feels as if the market’s concerns have shifted to thoughts of too much tailwind, forgetting any sort of headwind can exist. In our view, this is human behavior at its worst and something we seek to avoid. In the examples above, we don’t intend to be doomsayers but, rather, we attempt to illustrate the elusive nature of risk. We do not truly believe any of these scenarios might or will come to pass precisely because such situations rarely occur as envisioned. We merely point out that there are risks related to human behavior that no one is taking into account. And that’s exactly why we use the actuarial processes similar to those used by insurance companies to focus on the known data in the financial world…in 2Q21 and going forward.

 

THE STATE OF THE STOCK MARKET ACCORDING TO THE HUMAN FACTOR

New Age Alpha’s proprietary Human Factor methodology is designed to deal with the vague and ambiguous information in the stock market. As conjecture and speculation have overtaken disciplined analysis, the Human Factor – the probability a company will fail to deliver the growth implied by its stock price – has become pronounced. As of March 31, 2021, the median Human Factor of all companies in the S&P 500® sits at 53.4%, compared to an historical average of 47%.

Let’s take a look at our global universe of nearly 6,500 stocks for additional insight.

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Using our H-Factor System, we can get a view of the market en totale based on the dispersion of these nearly 6,500 scores. As of March 31, 2021, the median Human Factor for these global stocks was 47.4%. If split down the middle, slightly more companies are underpriced (3472) by the H-Factor System than are overpriced, as would be expected by such a median value. Unto itself, this might imply that a stock-picker is more likely to succeed despite the slightly less than 50% median average. If we take a closer look at the dispersion of these scores, however, we see a fascinating dichotomy taking shape. Broken down by quadrants, we find that the H-Factor System can reveal even more about the market:

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While 58.9% of all companies land in the middle two quadrants, only 41.1% reside at the opposite ends of the spectrum. To us, this displays one of the hallmarks of a gambler’s market. While yes, one has a 23.4% shot of picking a top tier company correctly, one also has a 17.7% of picking incorrectly. The difference amounts to 5.7% chance. However, the difference between the combined middle two quadrants and the outliers is 17.8%. Effectively, the Human Factor is telling us that if patience and trust in probabilities are exercised, you may be more likely to outperform by simply avoiding the losers. This is the beauty of the H-Factor System. By focusing strictly on probabilities, we learn that what appears to be an underpriced market actually has much more going on under the hood.

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As we look forward to reopening and the second quarter of 2021, our H-Factor System also shows certain geographic trends. Using the mean score to show the probability that a geographic area will fail to deliver the growth implied by its collective stock prices, we see a fairly wide dispersion from top to bottom. Interestingly, while US stocks, at 47.1%, hover at the mean of 47%, areas such as China, Canada, and Australia have scores in the low 30%s. This means they may be underpriced since a low Human Factor indicates vague and ambiguous information has NOT been priced into the stocks. South Africa and Japan both have scores at least 10% higher than the mean average, however, and South Africa’s is double that of China.

In our view, it’s tempting to view the recent interest in Emerging Markets as the reason for the heightened mean scores in South Africa and Korea. After all, since the Human Factor is a probability based on the growth implied by the stock price, a surge in price might suggest exaggerated effects of human behavior. However, China’s score remains appealingly low. This suggests that the interest in Emerging Markets either wasn’t applied uniformly or that underpriced opportunities in China may remain, or both.

 

THOUGHTS ON THE FIXED INCOME MARKET

As we write this, the High Yield (HY) market is essentially unchanged on a year-to-date basis. The Bloomberg Barclays US Corporate HY Index is up 0.2% so far this year, with BBs posting a loss of 0.88%, single Bs gaining 0.41% and CCCs outperforming strongly, gaining 3.43%. We believe these results are reflective of a continued “risk-on” trade in high yield, tampered late in the quarter by a dramatic sell off in treasuries. In our opinion, investors have continued to impound vague and ambiguous information into bond prices, just as they have for stocks.

With quarterly filings out of the way, it was largely confirmed that credit fundaments for HY companies remain weak, despite some quarter-over-quarter improvements for a second consecutive quarter. While we believe COVID-19 is responsible for most of the deterioration in fundamentals, high yield investors must watch for signs of issuers prioritizing equity-friendly actions over improving their credit metrics as business begins to recover.

As we look at the rest of 2021 we are comforted by solid economic growth and continued monetary and fiscal stimulus. We expect improving credit metrics and the seemingly never-ending search for yield will help performance. However, the high yield market is trading at historically tight spreads while leverage is very high even as the pandemic continues to remain a risk.


CONCLUSION

If the second quarter of 2021 is anything like the preceding five quarters, we should expect the unexpected. No one saw the pandemic coming, much less the near-instantaneous recovery of the market while still in the throes of it. And, going one step further, who could’ve anticipated the rise of the “retail investor” as a result? The sequence of events blew apart prognosticator’s carefully structured analysis worldwide. To try to predict what will happen next is folly. We believe the only approach that works across all time periods and all market cycles is the avoidance of the risk of human behavior.

 

About Us

New Age Alpha is a global leader in building actuarial based asset management solutions that aim to inure investor portfolios against an idiosyncratic risk caused by human behavior. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm specific risk, that can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behavior. Through our research we have identified a dramatically differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation to our investment approach, we have built a range of actuarial based asset management solutions that aim to mitigate and inure investors’ portfolios against this risk.


Disclosures

Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. It is not possible to invest in an index. An investor utilizing the Human Factor may experience a loss. No client or prospective client should assume that any information presented in this data set serves as the receipt of, or a substitute for, personalized individual advice from New Age Alpha or any other investment professional. All research and data are simulated and should not be considered indicative of the skill of New Age Alpha. The research data presented in this document has been calculated backwards in time and is not a contemporaneous record of actual assets managed by New Age Alpha.

The accuracy of the Human Factor is materially reliant on the integrity of the information utilized in the calculations, including any assumptions and or interpretations made by the user about the data. Data discrepancies, and user assumptions, can all contribute to differing outcomes. The underlying assumptions and processes presented herein are subject to change. New Age Alpha reserves the right, in its sole discretion, without any obligation and without any notice, to modify the information contained in this material, or to correct any errors or omissions in any portion of this material at any time.

The above statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. The views stated herein are only current through the date stated and are subject to change at any time based on market or other conditions and New Age Alpha disclaims any responsibility to update such views. Any Human Factor information or charts presented herein or utilized in the Human Factor system are provided for illustrative purposes only and should not be construed as providing investment advice or as a recommendation to buy or sell any particular security. The Human Factor information provided herein is a snapshot taken at a particular point in time and any analysis or information contained in this document is outdated and should not be relied upon as investment advice. Moreover, the information presented in this document may have changed materially from the date on which it was created. New Age Alpha may or may not currently own the securities at the times set forth in this article. There is no intention for New Age Alpha to include these securities in its portfolios unless it becomes part of the established universe of eligible securities that are part of each specific investment strategy (e.g. the S&P 500®). It is important to note that there can be no guarantee that the application of the Human Factor to investment portfolios or certain stocks or securities can produce profitable results.

All New Age Alpha trademarks are owned by New Age Alpha LLC. All other company or product names mentioned herein, including S&P® and Dow Jones® are the property of their respective owners and should not be deemed to be an endorsement of any New Age Alpha product, portfolio or strategy. S&P Dow Jones S&P® is a registered trademark of Standard & Poor's Financial Services LLC ("SPFS”) and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC ("Dow Jones").

 

Julian
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Co-Written by Julian Koski, Co-Founder and Chief Investment Officer,  Andy Kern, Senior Portfolio Manager, and Matthew Waterman, Investment Writer