ALPHA SOURCES

DECEMBER 11, 2017

 ALPHA SOURCES
MARK TO MARKET
B arring a disaster in the final trading
sessions of the year, the portfolio
will return about 5%excluding fees
and dividendsin 2017. This is a far
cry from the nearly 20% of the MSCI
World, but better than a hole in the
head. The good news was concentrated
in the first half of the year. Profit-taking
trades in Wells Fargo, Sabadell and
Japanese equities added to the strong
performance. From spring onwards,
however, performance hit the skids,
and only recently have returns started
to improve. Slumps in General Electric,
Xper have been the primary drags, but
the dumpster fire has been more broad-
based than that. A 15% allocation to
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gold and commoditiesindustrial and
softfor example, havent done me any
favours either. Neither have exposure
to producers of generic medicines
and other small-cap pharma firms.
Finally, various attempts to hedge out
impending, but ultimately non-existing,
sell-offs in the market as a whole also
have hurt. Syntel and Urban Outfitters
have been rising from the ashes in
recent months, and I am hoping that
further mean reversion will reach the
rest of the portfolio next year. Given
where we are in the cycle, the risk of a
balanced equity portfolio losing money
is rising. But lets see whether I cant
come up with some ideas.
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ABANDON ALL TECH IN 2018? contrast, if tech stocks underperform,

The relentless bull market in precedence in this cycle suggests that
technology stocks has been the main other sectors will take over. I am in
story in global equity markets this year. the latter camp. I think tech will
In the U.S., the FANGs have gotten most underperform in 2018, but that
of the attention, but Chinese behemoths other sectors will mean-revert to
such as Alibaba and Tencent also have the benefit of long-only managers.
made their mark. Investors affinity for But what to buy then?
growth over value, and the bet that tech The first chart below suggests that
stocks seemingly unchallenged market financials, telecoms, health and energy
power are making them invincible, have are where investors should look for
been influental catalysts. As I show opportunities. Digging deeper into
below, the preference for growth over GICS 2 sectors indicates that media
value is in part related to the yield stocks also could do well. Stock pickers
curve. A flat curve tends to provide need to be on the ball here though.
tailwinds for growth. With respect to In particular, the efforts to consolidate
market power, no one can argue against media and telecoms into something
the power of big tech. My spider sense which can challenge big tech are riddled
tells me that antitrust authorities are with risks for investors. In theory, it will
keen to have a look at large tech, but lead to fewer and stronger companies,
will they do so in 2018? Probably not. but which ones that come out top isnt
We have to start with the tech stocks clear at all at this point.
because the fortunes of equity investors By contrast, everything else is
rely on what happens next to them. For expensive and is holding on to punchy
starters, bears hoping to sell the market trailing returns, indicating that further
lower need tech stocks to stumble. upside is limited. Industrials and
There is no way that shorts will consumer discretionaries, in particular,
have any joy unless tech cracks. By look vulnerable based on valuations.

fig. 01 / Defensive value in 2018? fig. 02 / Look to the right for opportunities in 2018?

MSCI World, GICS 1 sectors, valuations vs trailing returns Valuation Z-score, 0 = fair value (Left) Market is cheaper compared
MSCI equity indices, total returns, y/y% (Right) to its long-run average.
1.0 2 50
Y: Valuation Z-score, 0 = fair value

Telecoms 45
0.0 Financials Healthcare
Energy
40
0
-1.0 35
30
-2.0
Materials -2 25

IT 20
-3.0
Utilities 15
Consumer stap
-4
-4.0 Consumer disc 10
Industrials 5
-5.0
0 5 10 15 20 25 30 35 40 45 -6 0
X: y/y returns, in % ex-dividends ZA DK US PE NZ IN CN AU SW ID JP TH SE BR EZ CA KR MX RU UK CL MY TR CO

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The second chart above is similar to the
first, but due to lack of space, I cant
plot the data in the same way. It shows
that all major global equity markets
are up on the yearin local currency
termsand that the majority of them
are expensive. China, Denmark, South
Africa, the U.S. and Peru look like the
most exposed to deliver poor returns
next year. Peru is an interesting outlier
here given that many other LatAm
markets seem relatively attractive.
Speaking of which, Colombia,
Malaysia, Russia, Turkey, Chile and the
U.K. come out top. Of these, Turkey
is the riskiest proposition in light of
the political uncertainty and what
appears to be a full-blown balance-of-
payments crisis. The U.K. is interesting
too. It makes sense for U.K. equities
to perform well in 2018 in light of the
rising likelihood of a soft Brexit. But if
this expectation also leads to a rally in
sterling, it ought to be harmful for the
FTSE, at least in local currency. Finally,
markets cant be sure that the deal
signed between the U.K. and the EU last
week will stand the test of time.
fig. 03 / The key for value to outperform in 2018? fig. 04 / What is value anyway?
U.S. yield curve, 10-year less 2-year, % (Left)
S&P 500, value less growth, level, (Right)
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
09 10 11 12 13 15 16 17
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Elsewhere, the portfolio already
is exposed to Colombia, and I am
considering adding Malaysia. I am not
sure about Russia, to be honest, but I
havent looked into it at all, so I best
just stay silent on this one.
VALUE OVER GROWTH IN 2018?
The final two charts below finish this
piece where it started. Valuations in
U.S. equity sectors suggest that value
will outperform next year. But for that
to happen investors need to imagine a
version of the world in which the yield
curve steepens. I am open to that,
but the important question for me is
whether it happens because of falling
short-rates or risig long-rates. I cant
quite decide which one I am buying.
Finally, investors can optimize their
exposure to value by realising that
the headline value and growth indices
include a lot of the same names,
especially on the S&P 500. A pure value
large-cap strategy could avoid the
headline ETFs by just buying Berkshire
Hathaway, the major financials and
energy, as well as AT&T.
1.00
0.95
0.90
0.85
0.80
0.75
0.70
0.65
18