Alpha DNA – Year End 2018 and December Update

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Markets in 2018

Despite the many market events across all of 2018, it will be remembered by most for its volatile 4th quarter. Fear took hold of the markets and virtually every asset class that was up reversed course and finished the year down. All of the major asset classes finished negative for the year: equities, bonds, hedge funds & alternatives, commodities, and real estate.

No asset class was spared. In fact, in Q4, the value equity category out-performed the growth category for the first calendar quarter since Q4 of 2016! The rotation to value in a market downdraft is always a sign of fear and increased defense.

While public opinion seems to focus on the Fed for the market challenges in Q4, we’d like to point to another equally important factor: weakening forward growth estimates. Forward growth expectations were being revised down consistently in Q3 and Q4 and when this was combined with poor Fed communications, the markets began to panic.

Markets moving forward

Our strategies are highly dependent on analyst views and growth consensus. As a result, we have a very good view of forward market growth expectations. As we mentioned earlier, our view shows us that forward revisions have been trending downward for two consecutive quarters across the equity spectrum.

But it is important to note that the rate of downward revisions is NOT yet consistent with what we have seen ahead of past recessions. So, any fear that we are headed toward a recession in 2019 seem overblown. In other words, growth is slowing – but there is still growth. Fears of contraction are a bit overblown.

That leaves us constructive on the markets for 2019. After all, the expectations still imply growth in the economy and earnings. But this upcoming earnings season will be critical to where the markets finish in 2019. Companies will provide guidance on 2019 numbers and that will inform all forward expectations of growth. If the downtrend on revisions continues and reaches a certain critical level, the worries about growth could grip the market again and we could see renewed selling pressure. We think this upcoming earnings season is a key litmus test for the markets in 2019.

Managing Risk in 2018

Our proprietary signals saw signs of risk in late September and early October. We increased defense in the long-short portfolios on October 8th. We are happy we took that step but also wish we had used more defense than we had. Hindsight is always 20/20. In late December, our posture signals reached levels rarely seen. We took steps to get more defensive in the portfolio and took the Long-Short portfolios to market-neutral, which is where we remain today.

When we look back on these two risk management calls, the results are mixed. Of the first call in early October, we are happy with the decision to reduce risk but unhappy with the tactical execution – in that we wish we had gone more defensive. With the call in late December, we have the inverse situation. We are not happy with the risk decision but the execution has been solid. Despite moving to market-neutral in the long-short strategy, we are still producing several points of positive return in the portfolio. That is because the long portfolio is out-performing the short portfolio.

Managing risk in 2019

We are currently in our most defensive posture in our portfolios and we fully expect that our signals will cause us to go bullish again some time in Q1. We are seeing a few ‘green shoots’ in the signals but only further market data can compel our posture to change.

Even with the prospects of more risk exposure in 2019, we fully expect to see more posture changes in 2019 than we would see in a typical year. This is because heightened volatility is almost certainly going to be a common theme in the markets this year. It is rare to see a sell off of the magnitude we just had without some effort from the market to re-test those lows before moving higher.

In fact, when looking at our posture scores in the past when they reached the kind of crescendo levels they reached in late December 2018, the markets have re-tested the lows in 9 out of 10 times looking back on our data. We hope for the market’s sake that 2019 will be that 1 out of 10 times – but we shouldn’t count on it. As a result, we expect the posture to be active in 2019.

Our strategies in 2018

Despite the negative returns in 2018, there were some positives when we look back on the year. First, our hedge fund beat its benchmark and the broad markets. In fact, it was even positive in gross returns before its management fees. This is the unconstrained version of our strategy.

Second, we launched a new set of algorithms in January 2018 that we call our Revisions algorithms. These algorithms were used in all of our strategies in 2018 and are complementary to our existing Beats algorithm. The Revisions algorithms are designed to find companies likely to experience analyst revisions based on hidden demand trends. These algorithms finished the year positive in returns despite the market downturn in Q4.

The total AUM in our strategies tripled in 2018 and we are thankful to our clients for trusting us with their increased capital commitments.

Our Strategies in 2019

We extended our streak in 2018 of finding Revenue surprises and EPS surprises in our Bull portfolio around 80% of the time in our portfolios to NINE straight quarters. The streak is still alive going in to 2019. In the end, our ability to deliver alpha in our portfolios will be linked to that characteristic more than any other.

We expect markets to be volatile but for earnings beats and misses to be rewarded more consistent with past quarters. We also expect to be able to use our short individual stock calls more frequently in the unconstrained version of the strategy given our expectation of more market volatility.

alpha-dna performance chart through 12-31-2018

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