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Big U.S. money managers signal a shift in tides

It's going to be hard to beat this year's nearly 20-per-cent gain in the S&P 500, and most experts are warning investors to temper their expectations over the next few years.

Sure, there's a good chance stocks continue to rise because of strong corporate profits and impending tax cuts. Global economies, including that of the United States, are expanding and corporations are sitting on mountains of cash to invest or return to shareholders.

These catalysts aren't going to disappear when the ball drops at midnight on New Year's, but some big money managers are cautioning that markets simply can't continue to keep the same pace.

Vanguard, one of the world's largest money managers, has forecast gains of between 4 per cent and 6 per cent, for example, and U.S. names are seen trailing international stocks.

Joe Davis, Vanguard's chief economist, has argued that rising market returns have in some cases exceeded improved company fundamentals. Elevated stock valuations, combined with continued low volatility and low interest rates (even if they do inch up with every U.S. Federal Reserve hike expected) don't add up to big market returns going forward, he has said.

Over the longer term, the forecasts aren't pretty according to some. Jeremy Grantham of GMO projects a diversified 65-per-cent stock/35-per-cent fixed-income portfolio today will produce real returns of between 1 per cent and 3 per cent over the next 10 years, given where valuations and interest rates are today.

It is the same idea as a fund growing so large, its future gains aren't expected to keep up with past gains. Billionaire investor Warren Buffett has said so much of his own company, Berkshire Hathaway, noting that eventually it will get so big it won't be able to invest earnings back into the company, but would have to consider other methods, such as share buybacks and dividend payouts.

The markets' relative calm – volatility is near historic lows, despite all the political noise in Washington and there has been a distinct lack of big selloffs – has the potential to encourage bad behaviour. For instance, investors continue to pile into stocks and stock funds, shrugging off any warnings. This would seem to confirm an inherent bias in investing mentality. When stocks are falling as they did in the 2007-09 financial crisis, investors fled believing stocks would never rise again. The reverse seems to be true when stocks have been climbing forever.

Richard Thaler, who was named a Nobel Prize winner this year for his work in the field of behavioural economics, explained that humans tend to think that what is happening now will continue to happen. That is why they chase hot stocks and dump their holdings when the market is falling.

High-flying tech stocks have been large contributors to the broader markets' overall returns over the past few years, while value investing has fallen out of favour up until just recently. Investing in the indexes, which are weighted toward the biggest companies, has been a popular way to ride this tech boom. That's because the biggest S&P companies are the biggest tech names: Apple, Facebook and Amazon rank in the top 10, as do Google parent Alphabet and Microsoft.

Buying the whole index has allowed investors to ride the bull up, but it does pose some risks, over-concentration in the biggest stocks and overexposure to the U.S. market among them.

If you think the big tech companies such as Facebook and Amazon have gotten too expensive, it may be time to look elsewhere, such as international investing opportunities and orphan stocks – those that aren't included in an index and that might get overlooked.

China's rapidly growing technology sector has been one place highlighted by analysts as a potential growth area, relatively cheap at least compared with this year's run-up in U.S. tech giants.

And investing in orphan stocks may add some portfolio risk since they are decoupled from the market momentum, but they also bring a possibility of better returns if a gem can be unearthed.

At Validea, we have developed portfolios that track the investment styles of several successful investors, choosing stocks using a batch of consistent criteria based on company fundamentals. Here are some of the top picks:

Toll Brothers (TOL-N) – This stock passed the test of three top investors: James O'Shaughnessy, John Neff and Peter Lynch. The luxury home builder's stock has a 15 multiple and long-term EPS growth of 18.6 per cent, but the stock recently dropped after the company reported lower than expected profit.

United Therapeutics (UTHR-Q) – This biotech clears the screen of three top investors, including Mr. Lynch, author and money manager Joel Greenblatt and Benjamin Graham. The Greenblatt model uses earnings yield and return on capital to rate all eligible companies. Using the combined ranking, UTHR is the 9th-highest-rated stock in the U.S. market.

NetEase Inc. (NTES-Q) – This Chinese game maker and social-media company passes the test of Mr. Lynch and Mr. Buffett, as well as Validea's momentum test – all three of which are very different investment models with a host of fundamental and valuation factors. The shares are trading within 15 per cent of their 52-week high, a sign the stock is close to breaking out for a new high.

Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock-screen service.

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