Equity investing for a new era: The return of alpha

The economy and markets have emerged from the pandemic fundamentally changed. For equity investors, we believe this means a different opportunity set than the one that prevailed over the past decade and a half ― and one that favors alpha (excess return) over beta (market return).

Key takeaways

• The era of easy money is ended. The post-pandemic era is setting up to be more volatile with greater differentiation across individual stocks.
• Beta, or market return, is sufficient when a rising tide lifts all boats. In the more traditional investing landscape now forming, we see alpha at the center.
• A more discerning market that prices stocks on their underlying fundamentals is an opportunity for skilled stock pickers to outperform.

It’s not 2019 anymore … or any of the 10 years that preceded it. The pandemic period, inclusive of the crisis response and aftermath, roused an entirely new set of circumstances upon which the economy and markets are just now establishing their footing. For equity investors, we believe this burgeoning regime change means a different opportunity set than the one that prevailed over the past decade and a half ― and one that favors alpha (excess return) over beta (market return).

The end ― and beginning ― of an era

Capturing the essence of the market regime now in formation requires context and reflection on the dynamics that existed prior to the current moment. The years following the 2008 Global Financial Crisis (GFC) were marked by 1) fragility and 2) accommodation. Households and businesses were recovering from a deep recession and fallout from financial and corporate failures. For its part, the Federal Reserve (Fed) cut rates to stimulate the economy and help consumers and businesses heal, propping up markets in the process.

Fast forward to 2020 and the COVID-19 crisis, a time marked by a global economic shutdown and restart and an unprecedented infusion of monetary and fiscal support that was far greater than that seen during the GFC even as the earlier crisis imposed a more potent shock to GDP. Consumer pockets were padded with stimulus money and demand for goods was great ― but supply was limited, having been disrupted by pandemic-related closures.

Today, economies are bearing the burden of supply-side inflation ignited by the crisis, accommodated by fiscal and monetary stimulus, and exacerbated by war in Ukraine. Central banks are now vigilantly raising rates to combat soaring prices. Sticky elements of inflation, such as wages, will be harder to bring down, setting the stage for higher inflation and interest rates for longer, just as stock valuations also are higher.

Investment implications: An alpha imperative

We believe the post-pandemic investment regime characterized by higher inflation, rates and valuations will require a new approach to equity investing. One implication of this new backdrop is lower market return, or beta, suggesting that a higher portion of equity portfolio returns will need to come from alpha, or excess return.

For the 12 years following the GFC, beta was abnormally high as valuations moved from very low to normal, and the differentiation in returns between individual stocks was slim. Investors bought the dips and, as a result, the drawdowns were quite short and shallow. The Fed also was willing to come to the rescue in the case of any wobbles. Beta was king, as well-supported markets provided extreme performance, resulting in an average annual S&P 500 return of 15% over calendar years 2010 to 2021.

In contrast, the era before the GFC featured longer and deeper equity market drawdowns, as shown below, meaning more volatility as well as greater opportunity for skilled stock picking to deliver above-market returns (or alpha). We see this dynamic returning and the outlook for alpha turning more positive.

To buy or not to buy the dip
Depth and duration of equity market drawdowns

Five factors favoring stock picking

While there are no crystal balls in investing and markets are notoriously unpredictable, we see various market dynamics taking shape that support the case for an alpha-centric approach to equity investing:

1. Equity market volatility that is more likely to increase than decrease

Equity market volatility, as measured by the VIX, has been relatively low in 2023 ― just as rates volatility has been high. This disconnect suggests ample uncertainty in the marketplace and greater potential for equity volatility to pick up. Geopolitical concerns, supply disruptions and a data-dependent Fed committed to fighting inflation are all likely to stoke bouts of volatility across time.

The market dips inherent in volatility can lead to mispricings, presenting opportunities for active stock pickers to purchase shares of companies with good prospects at a discount. While cyclical stocks are typically punished in a recession, we see opportunity in those that may be discounted beyond what their fundamentals suggest or that may be pricing in a deeper recession than we believe likely.

2. Stock dispersion normalizing from narrow levels, separating winners from losers

Stock dispersion was muted after the GFC with little difference in return across top and bottom performers. It was a beta-driven environment in which a rising tide lifted all boats. This reduced the reward to stock pickers, as there was smaller advantage to identifying “winners” or avoiding “losers.”

We see dispersion in earnings, valuations and returns increasing in the post-pandemic period, setting up an environment in which skilled stock picking can provide more meaningful contribution to portfolio outcomes. The chart below shows that the average dispersion across global stock returns in the post-pandemic period is up from the post-GFC period.

Wider variation in stock returns
Global stock dispersion and era averages, 2009-2023

3. Stock specifics (vs. factors) having greater influence on return dispersion

Our data further finds that the reason for this greater dispersion in returns is increasingly based on stock-specific variables and less on the factor characteristics of the stocks (e.g., growth vs. value, small vs. large), which were more dominant in 2020 and 2021. See chart below. While the continuation of this trend cannot be assured, we believe active selection focused on fundamentals can have greater bearing on investor outcomes. We also expect to see an increasing shift in focus from macro concerns at large to how individual companies are able to navigate an environment of slower growth and higher inflation and rates, making company specifics more important to investment decision-making.

Stock specifics driving dispersion
Decomposition of stock return dispersion, 2018-2023

A tale of two markets
S&P 500 Index performance by sector, year-to-date 2023

4. Currently narrow market breadth poised to widen

Market breadth is historically narrow, with 22% of the S&P 500 Index’s market cap attributed to the top five stocks as of June 30. This compares to just under 16% pre-COVID (year-end 2019) and 13% ahead of the GFC (year-end 2007), according to data from Refinitiv. Comparing the index’s market cap-weighted and equal-weighted returns illustrates just how much the mega-cap stocks ― primarily tech-related shares across IT, telecom services and consumer discretionary ― have driven index performance this year. See chart above. As the market increasingly acknowledges and values company fundamentals, we expect market breadth to widen beyond the current leaders and create greater opportunity for active stock pickers with the research capabilities to identify companies with strong fundamentals and attractive long-term growth prospects.

5. Artificial intelligence (AI) driving opportunity and disruption

Given its wide reach and immense potential, we see artificial intelligence (AI) contributing to increased dispersion in the marketplace. Among software companies, for example, the winners will successfully incorporate AI into their products and be able to raise prices while those that fail will become obsolete. Elsewhere in technology, we could see some companies using AI to increase profitability while others merely experience it as a cost of doing business. The impact is not limited to the tech sector. Across industries, we expect new business models will arise, powered by AI innovation, and others will be disrupted (e.g., call centers where humans are displaced by chat bots). Understanding of AI use cases, implications and risks across sectors, industries and individual stocks will have growing influence on investment outcomes, in our view

The return of differentiated returns

In the regime now forming ― the post-pandemic era ― stock valuations, inflation and interest rates are all higher. Supply is being constrained by demographic trends (aging populations and fewer workers), decarbonization and deglobalization, all of which are inflationary as companies spend to adapt. Going forward, the Fed is more likely to be in a position of having to fight inflation rather than bolster the economy, a less friendly scenario for financial markets.

Equities historically have been the highest-returning asset class over the long term, and we see nothing to alter that precedent. However, higher stock valuations than at the start of the prior regime plus higher interest rates means less return from markets broadly (beta). We see more dispersion in earnings estimates, valuations and stock returns ― and this suggests greater opportunity for skilled active managers to generate more alpha. The result, in our view, is that the years ahead will see active return being a bigger part of investors’ overall return profiles.