As 2007 winds down and we position our portfolios for the new year ahead, several big picture trends begin to emerge. I view the following four trends as both risk factors and opportunities for 2008:
1) The Return of the Day Trader: The volatility we've been seeing in the second half of 2007 is unlike any since the technology bubble. For example, the VIX has actually peeked its head above 30 several times in 2007. This has ramifications for both long term and short term traders. The long term folks need to pay more attention to when they get in and out of their positions because waiting an extra day or two could result in significant price swings. Even blue chip names can be up 5%, down 5%, and then back up 5% again over the course of just a few days. On the other hand, the short term traders love the volatility as it returns to levels where they can make a living trading in and out of positions on a daily basis. And of course, increasingly easy access to levered products such as ultra-shorts, derivatives, and high risk hedge funds only increases the volatility in the market. High levels of market volatility will be both a risk factor and an opportunity in 2008.
2) Market Segment Mean Reversion: I am a big believer in the concept of regression toward the mean in the stock market. I know that many of the best investment opportunities are created when market participants over or under-react to information. To some extent, I believe the simple concept of regression toward the mean can identify market overreactions and mispriced securities. Mean reversion information is useful for tracking long term trends such as the decline of the U.S. dollar (which by the way is actually up big time vs the EUR over the last several weeks for the first time in two years), mid term trends such as the underperformance of the financials sector, and short term movements caused by general market volatility and noise.
Mean reversion monitoring doesn't provide exact buy and sell signals, but it does provide a strong indication of differentiated risk reward profiles. It also helps investors determine where to best allocate their resources. Here are two examples of mean reversion I'm watching very closely for 2008:
Small Value Stocks: Since the 1930's, small value stocks have consistently provided higher returns than any other major investment style (click here for supporting research and data). However, over the most recent one and three year periods, small value has underperformed every other major investment style. I can't pinpoint an exact date when "mean reversion" will cause small cap value stocks to start outperforming, but I'm willing to bet it will happen. Small cap value exposure is a key risk factor and return opportunity that I'm monitoring closely for 2008.
Under-Performing Market Sectors (Media and Financial Services): Media stocks and Financial Services stocks have significantly under-performed the rest of the market in 2007. For example, check out the following 2007 Media stock price declines:
Comcast (CMCSA) is down 36% YTD,
New York Times (NYT) is down 27% YTD,
Time Warner (TWX) is down 24% YTD, and
CBS Corporation (CBS) is down 15% YTD.
Are these huge declines warranted, or has the market overreacted? Similarly, uncertainty about subprime exposure is a huge risk factor in the Financial Services sector, but does it really warrant stock price declines this extreme?:
Freddie Mac (FRE) is down 52% YTD,
Citigroup (C) is down 43% YTD,
Merrill Lynch (MER) is down 40% YTD, and
Barclays (BCS) is down 28% YTD.
3) A Better View of Diversification: Many investors have become too comfortable with traditional definitions of diversification, and as a result they've been getting burned. For example, many US investors thought they were diversified by holding every market cap, sector, and industry, but towards the end of the year they began to realize otherwise. The depreciating US dollar caused US only investors to miss out on double digit return increases because they weren't diversified internationally.
As another example, many of the big quant funds thought they were diversified by holding large portfolios diversified across various markets. However, in August they learned their specific quantitative strategies were not diversified enough, and the high concentration of funds using the exact same quantitative factors caused many of them to get wiped out in the quant quake. Another example is the small cap value investor. There are volumes of research articles demonstrating high return opportunities in small cap value stocks, but alas this is a multi-year strategy, and in 2007 small cap value has painfully under-performed the market. In 2008, it will be more important than ever for investors to recognize there are many different diversification fronts that must be considered.
4) The Black Swan: New York Times best-selling author, Nassim Nicholas Taleb, developed "The Black Swan" theory, and every investor in the world needs to watch out for it. The Black Swan is a "large-impact, hard-to-predict, and rare event beyond the realm of normal expectations." It's the left hook you never see coming. September 11th, Hurricane Katrina, and the collapse of Long Term Capital Management are all examples of Black Swans. No one knows what Black Swans lie in store for 2008, but rest assured they are coming; it's the price you pay to play. Just be ready, because every Black Swan creates a new opportunity.
Disclosure: Author is long MER