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Activists’ Alpha

December 4, 2014, 12:00 PM UTC
Alan Murray
contract Armin Harris
Photograph by Wesley Mann for Fortune

“Are markets in a bubble?” That was the question my colleague Stephen Gandel asked investor Cliff Asness when he visited our offices recently. And Asness, who earned his Ph.D. in finance under the tutelage of Nobel winner Eugene Fama at the University of Chicago, is arguably one of most thoughtful guys to address it. Fama is, of course, the godfather of efficient-market theory, which holds that in markets with perfect information, prices are rational and bubbles can’t exist. Asness made his fortune by parting ways with his mentor. He believes prices can temporarily get out of whack with true values, enabling smart investors to make money.

“Is everything in a bubble? My short answer is no,” said Asness. But his long answer gets more interesting. His analysis suggests that stocks and bonds are very expensive—“in the 85% to 90% range”—relative to their 100-year history. And while either has been at or above that range for 10 to 15 of the last 100 years, rarely have both been there at the same time. Something unusual is happening—probably linked to the unprecedented flood of money pouring out of central banks since 2008. (You can see segments from the Asness interview here.)

For investors that creates a conundrum. Investments are historically expensive. But the global economic realities underlying investments don’t justify the expense. Europe and Japan are back in the soup, and emerging markets have lost their mojo. Three of the four famed BRICs—Brazil, Russia, and India—are in serious economic distress, and the fourth (China) is teetering precariously.

A defensive retreat to cash is an unappealing option, given the minuscule returns to money-market funds these days. Gold hedging is even worse, as the absence of inflation is driving gold prices down from speculative heights. Smart shorting strategies by hedge funds—increasingly available to the average investor—might be a viable option, if excessive fees didn’t offset benefits.

So what’s a serious investor to do? That’s the fundamental question we tackle in our annual Investor’s Guide. Because of the unusual environment, we’ve devoted much of our attention to what you shouldn’t buy, not just what you should (see “Don’t Buy This, Buy That”). Needless to say, the “shouldn’t” list is a long one this year. Steer clear of social media—how valuable can disappearing photos really be? Manhattan real estate and collector’s art also seem to have reached the outer limits of rational pricing.

But elsewhere, there are openings. The latest tech boom, for instance, may just be beginning to infiltrate the broader corporate world, creating interesting opportunities (see “How to Invest in the Internet of Things”).

And then there’s the land of activists. They’ve earned hefty sums for themselves and their followers this year, and our Fortune Crystal Ball predicts another big year for these impatient and powerful investors in 2015. We’re not at all sure the activists’ ascent is a good thing for business, or for the American economy. This year’s attack on pharmaceutical maker Allergan, for instance, resulted in an acquisition deal with Actavis, which has declared its intent to cut spending on research and development. That can boost profits in the short term—a reason for investor enthusiasm. But what it means for new drug development seems less auspicious.

Likewise, we’re not particularly concerned about the quality of bread sticks or the salt in the pasta at Olive Garden. But there’s something deeply disturbing about a know-it-all investor like Jeff Smith being handed control of Darden’s entire board of directors (see “The Investor CEOs Fear Most”). Is that a step toward better corporate governance or a giant leap away?

Nonetheless, for investors looking to make money in difficult markets, the activists are delivering. And as long as that remains true, the stewards of the Fortune 500 will need to keep a wary eye.

This story is from the December 22, 2014 issue of Fortune.