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Living with a Bipolar Market

"Keep calm and carry on." That advice, originally given to British subjects during the dark days of World War II, applies equally to investors in this new risk-on/risk-off world. Success will require patient, dispassionate deep-dive analysis, nimbleness and the confidence to break with the crowd.

This blog is the first in a new series on Institutionalinvestor.com entitled Global Market Thought Leaders , a platform that provides analysis, commentary, and insight into the global markets and economy from the researchers and risk takers at premier financial institutions. Our first contributor in this new section of Institutionalinvestor.com is AllianceBernstein, who will be providing analysis and insight into equities.

Had enough of these nasty market mood swings? Better get used to them. From what I see, they’re not going to stop any time soon. This new environment will put traditional active managers to the test, but it is also producing plenty of opportunities for those able to adapt.

This bipolar behavior emerged in reaction to the credit crisis, and recent regulatory and accounting changes, which raised everyone’s risk radar. But, as my colleague Ted Mann and I learned in researching this topic, these lockstep risk-on/risk-off gyrations are also getting juiced by the growing popularity of index-based hedging and price-momentum strategies, which are largely used, paradoxically enough, to minimize unwanted market volatility. By binding individual securities tightly together, these new tools foster herd behavior and short-term trading. As a result, they magnify price swings and send correlations among stocks soaring.   

While index-based hedging and momentum strategies are likely to remain powerful influences on the market, their sway should wax and wane with shifting perceptions of risk. As uncertainties about the global recovery are resolved or loom less large, we expect the amplifying powers of these internal forces to drive up the equity markets, as they did in 2009.

Recent bursts of risk aversion have been tough on traditional active strategies that rely on distinguishing among individual companies to beat a benchmark. In their intense focus on near-term macro events, investors have ignored fundamental differences in valuations and earnings potential, which historically have been reliable drivers of outperformance.

The good news is that all this trend-chasing and short-termism have created significant mispricings that research-driven stock-picking can identify and exploit, especially for investors willing to look past today’s uncertainties to the long-term view. We expect active strategies to be rewarding in delivering premiums, but with greater variability over time.

A major theme for us has been the cheapness of excess cash and strong balance sheets. Short-sighted investors have been unwilling to pay up for strong free cash flows that could easily disappear if the economy stays anemic or that may be wasted in ill-conceived initiatives. Those concerns are understandable. That’s why we’ve concentrated on finding companies with long histories of giving back cash to shareholders or have a greater-than-average potential to increase cash payouts. It has also meant being more proactive about engaging with managements to gauge their cash-giving mind-sets.

Success in this new risk-on/risk-off world will require patient, dispassionate deep-dive analysis, nimbleness and the confidence to break with the crowd. As the British said during the dark days of World War II, “Keep calm and carry on.” 

Joseph G. Paul is the Chief Investment Officer—North American Value Equities

The views expressed herein do not constitute research, investment advice or trade recommmendations and do not necessarily represent the views of all AllianceBernstein portfolio management teams.

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