How do you capture alpha?
Simply 2 ways, perform higher than the benchmark in the bull market or fall less than the benchmark in a bear market.
And perhaps variants of this - performing average in a bull market but being unaffected in a bear market and anything in between like average in bear market but super high returns in a bull market.
Considering the double digit S&P 500 returns (2 years in a row), one must ponder what comes next - if anything 8-10% returns on average are not the norm (the swings are wider than you think)
If a bear market rare and unpredictable as it may be comes, one must be ready and watch for some signs.
ChatGPT provided some answers below and the truth is that high valuations simply isn’t a reason not to be invested or even selling (market timing fails).
A bear market in the S&P 500 doesn't typically start solely due to high valuations, but valuations can certainly play a role in triggering or contributing to it. Bear markets usually emerge from a combination of factors, including:
1. **Economic Slowdowns**: A recession or slowdown in economic growth is one of the most common causes of a bear market. Lower corporate profits, rising unemployment, and weaker consumer demand can all erode investor confidence.
2. **Monetary Policy Tightening**: When the Federal Reserve raises interest rates or reduces liquidity, it can reduce the attractiveness of equities. Higher rates make borrowing more expensive, which can slow down economic growth and reduce corporate earnings. It also makes bonds more appealing relative to stocks.
3. **Geopolitical Events**: Wars, political instability, trade wars, or natural disasters can introduce uncertainty and cause a sell-off in stocks. These events may lead to economic disruption or heightened risk aversion among investors.
4. **Investor Sentiment**: A shift in market sentiment, often influenced by a combination of news and expectations, can also cause a bear market. If investors start to fear a downturn, they may sell off stocks, triggering further declines. Fear and panic can cause overreactions, even in the absence of a fundamental economic collapse.
5. **Overleveraging and Financial Instability**: Excessive debt in the corporate or household sectors can lead to defaults or bankruptcies. Financial crises or liquidity problems can destabilize the broader economy and lead to a sharp decline in stock prices.
While high valuations can be a contributing factor—since overly expensive stocks may eventually face a correction if earnings fail to meet expectations or if the broader economy weakens—bear markets tend to be driven by these broader economic and financial forces.
-
From my sense of the markets - the main risks are likely 1 worldwide (but not in the US) and 3 (which is probably related to risks in Ukraine, China and Middle East) - but some of those are not new, and not really expected to escalate…but still something that could start the next bear.
My approach therefore remains the same (cautious optimism) - buy when entry is right, otherwise build up your war chest.
The alpha in the year ahead is likely in staying defensive. This includes I) Buying well at cheap valuations with potential catalysts, II) Selling or shorting if overvalued and III) Storing up a war chest in cash or short term bonds (<2Y) to prepare for deployment if and when Mr Market sours.
—-
Thoughts of this article is partially inspired from Carson group. See original article here (https://www.carsongroup.com/insights/blog/seven-important-things-to-remember-in-2025/)
