Buffett Versus the Robots
The current equity market environment invites comparisons with the golden era of stock pickers such as Peter Lynch and Warren Buffett. Correlations have broken down in the past few weeks, delivering losses to automated trading strategies and increasing the potential for careful analysts to find mispriced securities.
It may be too early to proclaim a new heyday for value investors. A key difference is that Lynch and Buffett weren't competing with an army of robots. In these machine-dominated trading times, the fastest hard drives and algorithms have been winning. They may have another round of victories in store.
The Dorsey Wright Focus Five index, which tracks an investment approach based on technical momentum indicators such as relative strength, dropped 10 percent this year as of Wednesday. By contrast, the FTSE RAFI US Equity Income index is up 1.2 percent. That gauge, developed by Research Affiliates, reflects a contrarian strategy of taking profits in rallies and adding more shares when markets drop excessively.
It's a reversal of the trend of the past few years. Automated strategies have dominated since the U.S. Federal Reserve embarked on an unprecedented monetary easing experiment that was followed by the world's most important central banks. Last year, the Dorsey Wright rose 6.6 percent while the FTSE RAFI lost 5.2 percent.
Go back further and value investors have the edge. The RAFI index has steadily outperformed market cap-weighted gauges such as the S&P 500. The RAFI takes fundamentals into account and rebalances to maintain its exposure to specific companies, selling when the market value rises too much and buying more when it drops. Indexes such as the S&P 500 inherently reflect more of a momentum strategy: As a company's market value rises, it takes up a bigger share of the gauge. That explains why Apple is such a big mover of the U.S. benchmark gauge. Investors tracking the S&P 500 automatically increase their exposure to stocks that are doing well.
Since January 2012 the RAFI has underperformed the S&P 500. Among the few times when this happened in the past were the dot-com bubble in the late 1990s and the real-estate bubble before 2008.
There aren't enough studies on what has changed. It could simply be that another bubble has started to burst. However, the waning of value investing may also reflect a fundamental change in the way the market operates, partly due to computer-driven momentum trading strategies. One indication that machines are shifting market paradigms is how price swings have become wider. The S&P 500's 360-day volatility has trended up since the advent of the Internet.
In tandem, individual stocks are swinging more widely against the benchmark gauge. The average historic one-month beta of the 504 members of the S&P 500 was at 1.08 on Wednesday, up from 0.99 a year earlier.
This means there's more potential to find undervalued stocks -- the kind of trades that Lynch and Buffett used to build their reputations. The caveat is that there may be too few investors following such a strategy to correct this mispricing and bring more stability to markets. Their numbers will have to grow, and they'll need nerves of steel.
In the machine age, it's all about momentum. With computers focused solely on which way stocks are going, good shares will be ditched when the markets drop and bad companies will be buoyed in rallies. Watch out for the robots: They're about to strike back.
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