Market inflection points (tops and bottoms) are characterized by extreme irrationality on the part of investors. At The MAC, we track several indicators that measure how “irrational” the market is being. In June, these indicators turned decidedly bearish. However, they have recovered over the last couple of months which would mean that the market is acting more “rational” and signal that the likelihood of an imminent bear market is seemingly diminishing. However, before I turned bullish, or at least neutral, on the market I discovered a strange occurrence that has made me increasingly skeptical of this bull market’s ability to rage on.
Over the past month, I discovered that there has been a broad based breakdown in Quant funds. For those who aren’t familiar with Quantitative Investing (Quant), it is the most rational (or the least emotional) form of active management. It involves using various computer algorithms that completely eliminate the human element from investing while trying to find unrealized value in the market. I have long been a strong believer in Quant investing and have used numerous Quant based money managers in my portfolio. Currently, the only Quant Fund I’m holding is the James Market Neutral fund (JAMNX). It performed very nicely through the first seven months of this year, but it took an uncharacteristic turn down in the last couple of weeks. Given that my clients livelihood is based on the performance of my portfolio, I was motivated to look into what was going wrong. I checked out other reputable Quant Funds, such as Bridgeway Funds and GMO Funds (I’ve invested in these families before, but they have too much beta for my current strategy). James, Bridgeway and GMO are all fund families with impressive track records. Here is what I found:
Fund........Performance..................Benchmark........Performance..........Difference
JAMNX……..-3.2%............................Cash……..........……0.5%.........................-2.7%
BRAIX…….…-3.8%............................NASDAQ 100…....4.8%.........................-8.6%
GMGWX…..…1.5%.............................NASDAQ 100…....4.8%.........................-3.3%
GMWMX….…1.5%.............................NASDAQ 100…....4.8%.........................-3.3%
BRAGX……...-5.75%..........................S&P 400…….....….0.6%.........................-6.3%
BRSGX…….…0.3%.............................Russell 2000….....3.1%.........................-2.8%
BRSVX…….…0.9%.............................Russell 2000……..3.1%.........................-2.2%
(Performance data is for 8/1/06 - 8/30/06, provided by Morningstar) Let me be clear that this is NOT an indictment of these funds. The reason I track these funds is that these managers have a history of adding significant value for their investors. The purpose of this illustration is to show how some of the best Quant Managers have underperformed the market in the past month which suggests that Quant/Rational investing strategies are currently not working.
So, what does this tell us? If proven, rational strategies don’t work in the current market, then it stands to reason that the market is acting irrational. Irrationality is a tell-tell sign of a market’s inflection point or in the case a market top. I’ll continue watching the performance of Quant funds along with all the other indicators that I have historically tracked in hope of getting some kind of idea on the direction of the market. In the meantime, I feel secure in minimizing my exposure to the stock market.