Chasing Alpha

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Includes: SPY, VIXY, XLF, XLP
by: Daniel Goldman

Summary

By focusing on passive investment strategies and hoping the bull run will continue, people are chasing alpha, not seeking it.

This has been successful because of the breadth of the bull run. But when the bull runs out, we will have to return to active strategies.

There are signs that the bull run is losing steam.

Back in March, I wrote "Stock Picking Is Dead! Long Live Stock Picking!" I pointed out how active and passive investment strategies go in and out of favor, depending on market cycles. Right now, a lot of money is being pumped into passive funds. But this is not really seeking alpha. It is chasing after it. Sometimes that is enough, but that is not why we are here. It is also a strategy which may not work if the bull run starts to really lose steam.

After the mixed results of banking stocks, BMO Capital Markets chief investment strategist Brian Belski came out and said "we learned today that stock picking matters. Because, again, look at what happened to Goldman and then look what happened with Bank of America and Citigroup, right?"

I agree. In the heart of a bull run, people can just throw money at the market and expect to make a profit, but we are no longer in the heart of the run. This does not mean that we will not see growth, but that growth will not be as easy to capture. This is apparent in a number of indicators.

Volatility and SKEW

We are seeing increased volatility on a sector by sector basis, even if VIX and VIXY are staying fairly low, and we are seeing mixed signals in individual stocks within a given sector. There is also a fairly significant expectation of tail risk in the S&P 500, as indicated by the CBOE SKEW index. As of Thursday, SKEW was up to 146.85, not the highest it has ever been, but still quite high. There is also an apparent upward trend which started around 2008.

CBOE Skew Index as of 4/18/2017

Bank Earnings

Furthermore, as I pointed out in "Breaking Down Bank Earnings," the source of the earnings, at least for banks, has been the recent bull run, and it has been largely the financial industry that has been pushing stocks higher. In other words, this kind of alpha chasing requires sustained broad growth.

It is because of the mixed earnings and the fact that so much of the earnings for banks right now are tied to the bull run that a sector rotation strategy might be a better option. I would not be heavily invested in the financial sector right now.

Sentiment & Valuation

As earnings season continues, we will learn more about just how much steam the bull run is losing, but as Bespoke Investment Group mentioned, bullish sentiment, according to the AAII bullish sentiment index, is faltering, while bearish sentiment has been on the uptrend.

This downtrend is coinciding with a market capitalization to GDP ratio which is incredibly high, and this is true, even when taking into account RFRR, something I mention in "Does the Risk Free Rate of Return Imply Stocks are Not Overvalued? - Trading Politics" and "Market Sentiment Vs. Reality." Indeed, according to valuations in the beginning of March, it would take almost 9 years, with no growth in the S&P 500, to return to "normal" valuations.

Consumer Staples

In times of economic uncertainty, consumer staples are not a bad option. Given the sputtering economy, one option might be to move some money out of at risk sectors and into consumer staples. This could still be done through switching from one sector fund to another. XLP provides access to the S&P 500 consumer staples sub-index and might be a better option than SPY.

I have also developed two Motifs which focus on defensive stocks. One was mentioned in "Trading Politics Monthly Compendium: Month of March 2017." The two Motifs are "LI-30" and "Low Income Boom." They are very similar, with the main difference being that LI-30 is designed more like a market cap weighted index, while Low Income Boom is an attempt to balance the Motif in a way that will maximize returns.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I move in and out of long and short positions and often trade VIXY, SH, RWM, etc.