Bulls Push Stocks To New Highs
What better way to celebrate a new President than to push stocks to new all-time highs? On Wednesday, the market surged as Joe Biden got sworn in as the 46th President of the United States. Interestingly, it was a rotation from the reflation trade back into the “Old Gaurd” of the FANG stocks that led the way.
In fact, despite hopes that the reflation trade would be the thing, it has been just the opposite. The chart below is the differential in performance over the last week between market-cap and equal-weighted markets. (FANG dominates market cap whereas equal-weight has a much larger weighting in industrials)
Notably, that rotation is a function of money managers repositioning portfolios to reduce risk. The risk gets reduced by moving from significantly extended and deviated areas of the market back to less extended or oversold segments. As noted last week, there is nothing screaming risk more at the moment than the small-cap sector.
Markets Queuing Up For A Correction
Currently, managers can’t afford to be out of the market and potentially suffer a performance drag. So, the rotation in the market reduces risk while still maintaining exposure to equities. However, as discussed last week, there is ample evidence that “everyone is currently in the pool.” Such leaves the market vulnerable to three risks:
More stimulus and direct checks into the economy lead to an inflationary spike that causes the Fed to discuss hiking rates and tapering QE.
The current rise in interest rates continues over higher inflation concerns until it impacts a debt-laden economy causing the Fed to implement “yield curve control.”
The dollar, which has an enormous net-short position against it, reverses moves higher, pulling in foreign reserves, causing a short-squeeze on the dollar.
The reality is that both a rise in the dollar, with higher yields, is likely to start attracting reserves from countries faced with economic weakness and negative-yielding debt. Such would quickly reverse the tailwinds that have supported the equity rally since March.
In the following video, we discuss why the markets are setting up for a correction over the next month of 3-5%. (We publish a daily 3-minute video click here to subscribe)
Important Note: A correction can take on one of two forms. The market either declines in price to alleviate the overbought condition, or it can consolidate sideways.
The Fed Broke It
In his latest letter to investors, The Financial Times reported that Seth Klarman of Baupost Capital blamed the world’s central banks for flooding the financial system with liquidity masking the US economy’s real health. To wit:
“With so much stimulus being deployed, trying to figure out if the economy is in recession is like trying to assess if you had a fever after you just took a large dose of aspirin. But as with frogs in water that is slowly being heated to a boil, investors are being conditioned not to recognise the danger.”
While the entire article is worth a read, his point is what we addressed previously in “Moral Hazard.” What exactly is the definition of “moral hazard.”
Noun – ECONOMICS
“The lack of incentive to guard against risk where one is protected from its consequences, e.g., by insurance.”
Take a look at the following chart, which is a clear example of investors adopting the idea of “insurance” against loss. (Charts courtesy of ZeroHedge)
Of course, given the price-to-sales ratio is at a record high, such also suggests that investors are vastly overpaying for future outcomes. When there is a lack of perceived risk, the outcome has always ended poorly without exception.
More Of The Same
As Seth Klarman notes, it is the unprecedented flood of global liquidity that is driving the mayhem.
“The Fed’s policies and programs have directly contributed to exceptionally benign market conditions where nearly everything is bid up while downside volatility is truncated.”
While The Fed’s drastic measures have arguably helped to boost economic activity and rescue ailing businesses (or more correctly, raise stock prices enabling issuance and collapse yields and spreads enabling issuance), Klarman warns:
“They have also kindled two dangerous ideas: that fiscal deficits don’t matter, and that no matter how much debt is outstanding, we can effortlessly, safely, and reliably pile on more.”
Unfortunately, 40-years of history have already shown us the problem with debts and deficits in economic prosperity for the masses.
Another decade of the same should about finish the job.
Signs Of Enthusiasm
Sentiment Trader had a great piece out on Thursday discussing sentiment and enthusiasm.
“The biggest challenge with this market, one we haven’t really ever had to deal with before, is the conflict between an impressive recovery from a historic selloff, superimposed against a backdrop of record levels of speculative activity.
Recoveries from a bear market typically take much longer. By the time they’ve recovered and been at new highs for a while, speculation comes in, markets plateau, divergences form, and sentiment cycles back down during a correction.
If we look at a typical Sentiment Cycle, then we basically went from enthusiasm to panic and right back to enthusiasm, all in record time.”
“There is little arguing that we’re in this part of the cycle. As the Knowledge Base article, “How do I use sentiment?” points out, this part of the cycle is identified by:
High optimism – CHECK
Easy credit (too easy, with loose terms) – CHECK
A rush of initial and secondary offerings –CHECK
Risky stocks outperforming – CHECK
Stretched valuations – CHECK
All boxes are checked there. More objectively, when we look at the correlation between the S&P 500’s price path lately versus the Enthusiasm phase of past cycles, there is a high positive correlation.”
Investors Are There
While none of this suggests the markets are about to crash, it does indicate that short-term risk/reward is not favorable currently. As SentimenTrader summed up:
“Sentiment is horrifically extreme and almost all signs are present, screaming at us that we’re seeing the kinds of behavior that are almost solely and universally seen at medium-term peaks in stocks.”
As noted above, a short- to intermediate-term correction to reduce current levels of exuberance would be a healthy thing. Longer-term, the dynamics to support a continuation of the bull market will become more challenging, particularly if inflation and interest rates start to push higher.
Our Job As Investors
Remember, our job as investors is pretty simple – protect our investment capital from short-term destruction so that we can play the long-term investment game.
A rate of return sufficient to keep pace with the rate of inflation.
Expectations based on realistic objectives. (The market does not compound at 8%, 6% or 4%)
Higher rates of return require an exponential increase in the underlying risk profile. This tends to not work out well.
You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste.
Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.
With forward returns likely to be lower and more volatile than witnessed over the last decade, the need for a more conservative approach is rising. Controlling risk, reducing emotional investment mistakes, and limiting investment capital’s destruction will likely be the real formula for investment success in the coming decade.