This article was first published on New Age Alpha.
It may sound like a bad joke: “What do prisoners, senior citizens and market investors all have in common?”. But for a certain subset of each, the answer is very real: Chronophobia or fear of the future. Classified in the DSM-5, its sufferers are often characterised by acute anxiety or distress when pondering future events. Prisoners might understandably suffer from it due to the length of their prison sentences and senior citizens, sensing the impending end of their time on earth, might also be justified. Market investors and their irrational fear of rate hikes, however? They simply need to grow up.
Growth vs. growing
Part of the problem, in our opinion, is a misunderstanding of how interest rate increases operate in the real world. A common perception is that higher interest rates make credit more expensive and, therefore, act as a tax on a borrower’s profitability. While this is largely true in the short term, it causes people to jump to a conclusion that is far from logical. You see, many investors see rising interest rates as a signal to shift from growth to value-style companies. They believe that the so-called “blue chips” are steeled against rising rates and, therefore, are more secure. And they knock growth stocks on the basis of higher loan servicing and related costs.
Our New York-based associates New Age Alpha, contest this notion. We believe there’s a chasm-wide difference between “growth” and “growing.” Over the long term, the impact interest rates have on valuation is a much stronger force than the cost of credit. This is because stocks are worth the present value of their future cash flows. But what does “present value” mean? It means the amount of the future cash flows discounted by the interest rate (sometimes called the “discount rate”). In other words, as interest rates go up, so too does the discounting of future cash flows, making those future cash flows now worth less. And also, the stock.
Don’t cry over spilt milk
For a long time, it felt like the market was only asking one question regarding interest rates: “will they?” or “won’t they?” But this type of market forecasting didn’t account for what may actually happen after such increases. This is where we find ourselves now, amid a very large rotation from growth to value stocks. In this case, investors anticipated the rate change and effectively repriced stocks before it even occurred. This drove the price of value stocks higher while beating down growth stocks, meaning the former now required more growth while the latter required less. And who do you think is going to win that race?
Worse yet, this macro-movement ignored research showing little relation between interest rates and the ability of value to outperform growth. For example, Thomas Maloney and Tobias Moskowitz, in a 2020 working paper, argue that the relationship between rates and value stocks is too complicated to pin down and any observed correlation is likely random variation.
In essence, the best-case scenario for those investors flocking to value is that interest rates do, in fact, impact growth stocks and they merely overpaid for safety. But if interest rates do not have such an effect? They may have sold growth at a loss and paid a premium for value.
Because, you see, that’s the most important question to ask: What is the probability a company will fail to deliver the growth implied by its stock price? A great company at a bad price can actually be a terrible investment. Meanwhile, a so-so company bought as a bargain can be a slam dunk.
That’s why it’s so important to focus less on scary macro-market movements and more on a company’s probability of delivering growth.
This is why at Global and Local Asset Management we put a number to this probability by using New Age Alpha’s developed system called Avoid the Human Factor (H-Factor). New Age Alpha’s proprietary methodology is designed to systematically measure the amount of vague and ambiguous information impounded into a stock’s price. By putting a number to this risk of human behaviour – the Human Factor – we believe we can measure it and avoid it. In this way, we believe we can produce a differentiated source of outperformance in any investment universe by aiming to simply avoid the losers.
As was shown in New Age Alpha’s recent piece about interest rates, the link between rates and future stock returns is distorted at the very least, if not utterly uncorrelated. This makes certain investors’ Chronophobia all the more bewildering. Just as most grown-ups know the boogie man isn’t real, so too do they recognise that a single action often results in varied, unpredictable actions a la The Butterfly Effect. In a complicated market full of unintended consequences, rising interest rates are merely a single action bound to result in myriad reactions. It’s downright childish to think otherwise.
At Global and Local Asset Management we firmly believe in stripping out all vague and ambiguous information from the investment process. This is why we use New Age Alpha’s developed system called Avoid the Human Factor (H-Factor). The H-Factor measures the probability a company will fail to deliver the growth implied by the stock price. This risk is caused by investors interpreting vague and ambiguous information and impounding it into a stock’s price in a systematically incorrect way. The lower the Human Factor, the more likely vague and ambiguous information has NOT been priced into the stock. The H-Factor System is a free comprehensive portfolio tool that enables investors to apply our Human Factor metric to over 6 000 stocks, ETFs, global indexes, and their own portfolios.
New Age Alpha is a global leader in building actuarial-based asset management solutions that aim to protect investor portfolios against this idiosyncratic risk caused by human behaviour. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm-specific risk, which can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behaviour. Through New Age Alpha’s research, they have identified a differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation of their investment approach, they have built a range of actuarial-based asset management solutions that aim to mitigate the risk of human behaviour.
If you would like to know more about how the Human-Factor score tool works and how we “Avoid the Losers”, then please contact us at Global & Local Asset Management.
Thomas Maloney & Tobias J. Moskowitz, “Value and Interest Rates: Are Rates to Blame for Value’s Torments?” https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3608155, SSRN. 6/16/2020.
Access Date: 4/25/22
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