What to do when out of sync with market?

After a banner year last year for growth and momentum, 2021 has been a historically frustrating year. With the S&P up double digits again YTD it is surprising that certain sectors are drastically underperforming. So what do you when your strategy is out of favor while the general market doesn't show any signs of weakness? If you invest long enough all investors and managers will go through difficult periods. The key is to know your strategy in and out and know when it is time to be aggressive and when it is time to be more risk adverse and selective. If we take a quick look at some data and statistics we can get a better idea of what is being rewarding in this environment.  

Lets take a top down approach and look at which asset class is leading. We can see that commodities are in the lead as bonds lag drastically. 

 Commodities have been on fire.

If you want a reason for why commodities are surging we can look at the recent March PPI prices:

• Plywood (construction): +53 percent vs. last year
• Cold rolled steel (durable goods): +75 pct
• Copper (construction, durable goods): +43 pct
• Corn (food, animal feed): +44 pct
• Wheat (food): +32 pct

One of the big surprises of the first quarter was the historic rise in interest rates. The 10-year treasury note started the year around 90 basis points roughly doubling to 175 basis points. Albeit from a very low starting point, the 10-year yield put in the biggest 40-week rise in rates, by a long shot, going back 50 years. Below shows how dramatic the rise in yields has been YTD across duration's.

 

The increase in yields put the biggest pressure on high valuation growth stocks. Many growth stocks are in bear market territory even with the general market positive on the year. This bifurcation is the exact opposite of what worked last year. Toni Sacconaghi, a longtime technology analyst at Bernstein, encapsulated the dynamic in a fascinating piece of research. “He points out that, in 2020, investors seemed to be buying techs almost because of their high price tags. In fact, if you divide the tech universe into quintiles ranked by price/earnings ratios, the returns were lowest for stocks with the lowest valuations—and highest for those trading at the loftiest multiples. The average tech issue outpaced the broad market by 28 percentage points last year, but those in the top quintile outperformed by 60 percentage points. Writes Sacconaghi: The more expensive a stock was in 2020, the better it generally fared. But investor behavior is shifting. Tech shares have underperformed the broad market by about four percentage points this year, according to Sacconaghi. The most expensive names are running 10 points behind and the stocks at the other end of the valuation spectrum—the cheapies—have beaten the market by about 6%. In short, what went up is indeed starting to come down, he writes.”

The correction in high quality growth names will set up future opportunities, as YTD is a tale of two tapes and the opposite of last year. There was a huge rotation out of growth and into value, small caps, and the reopening theme. Below is a good representation of the shift out of growth and into value. It is a ratio chart of the VUG (Vanguard Growth ETF) to the VTV (Vanguard Value ETF). When it is rising, growth is outperforming which we see with the historic rise last year. This trend started to stall out in the fourth quarter of last year and broke down in the first quarter of this year as money rotated away from high growth and into more value centric ideas. It now has the look of a big head and shoulders top with a retest failure.

When we drill down to market capitalization we can clearly see smaller caps are outpacing large caps. 

Lastly is a list of sector returns year to date. When beaten down energy and financials are leading the market that is not a ripe environment for growth. The current market clearly favors cyclicals and commodities. 

Now that we have an idea what is working and what isn't we can look at a few data points that gives some future potential. A few studies from Ryan Detrick show conflicting possibilities. Even though we are entering the worst 6-month stretch of the year, based on some recent data the future looks brighter. 

 

A second tweet from Ryan Detrick shows how this current bull trend could be getting close to exhausting itself in the short term. 

As we enter the sell in May and go away theme for the next six months, one data point helps back up this case. A recent note from DataTrek research shows "the latest Investment Company Institute money flow data for long term mutual/exchange traded fund flows paints a less optimistic picture. We now have data through April 28th (essentially month end); here’s how it looks:

• Fund investors redeemed $17.8 bn from US equity funds in the final week of April, enough to flip whole-month flows negative to the tune of -$7.8 bn.

• There were also $4.6 billion in non-US equity fund redemptions, but April’s total is still positive by $17.6 bn.

• Fixed income fund flows, by contrast, were strong last week (+$19.2 bn) and April as a whole looks like inflows will total $76.2 bn. That’s the best month for this asset class since January’s $93.8 bn of inflows.

• Commodity fund (mostly physical gold) inflows last week were slightly positive (+$119 mn) but April’s outflows still total $1 bn.

Takeaway: it’s just one week of data, but the sudden and sizable reversal in US equity fund flows after 2 solid months of inflows isn’t something we can just dismiss, especially given the money market fund data. Perhaps investors are starting to sell positions with large capital gains (those would more commonly be in US vs. non-US equities) now that the current Administration’s tax plan is out. Perhaps stimulus money going into US equity funds has run its course. Perhaps late April’s sales were just rebalancing. Perhaps it’s all of the above. One thing is for sure: it will be much easier for US equities to continue their rally if flows turn positive again. We’ll know soon enough."

The question is what do we do when our strategy is out of favor. I have been in the business long enough to know that styles ebb and flow with market cycles. Not one strategy dominates every market year in and year out. Where most amateur investors fail is they get complacent and chase the next hottest investment product. However, if you know your methodology and trust the process you have confidence that opportunities will eventually present themselves. Sometimes the best trade is to do nothing while the hardest trade is to keep powder dry while reducing risk sitting patiently for asymmetrical bets to turn up.

A quote from Dr. Brett Steenbarger sums up how a trader should react under uncertainty, "that is where meditation and self-control techniques learned through biofeedback can be very helpful. If market volatility has picked up, there will be plenty of movement to participate in. The key is standing back, slowing yourself down, consulting the data and then looking for opportunity. Because the volume and volatility are coming from large participants in the marketplace, their behavior can create significant directional opportunity. You just want to be at your mindful best at those times so that you size positions properly and don’t let the excitement lead to overtrading. A lot of money can be lost quickly under chaotic conditions."

Crash Imminent?

If you listen to the media they are always taking about the next crash. Based on their track record you have to take it with a grain of salt. Lets look at the actual data and make a more informed decision instead of chasing the next rumor. 

According to the latest BAML survey the only reason to bearish is there is no reason to be bearish. Essentially that means that sentiment is so positive everyone expects the market to continue higher. When fund managers are all positioned in the same direction it often is useful to be a contrarian and play devils advocate. Asking some simple questions and probing the consensus view can keep you from being sucked into the heard mentality. Lets look at the current BAML fund manager survey to see how bullish the current opinions are. 

BofA February Global FMS takeaways

Bottom line: the only reason to be bearish is…there is no reason to be bearish: FMS sentiment on global growth at all-time high, V-shaped recovery finally consensus, cash levels @ 8-year low, equity & commodity allocations highest since '11 (the last year both had negative returns), only 13% say it's a bubble… BofA Bull & Bear Indicator @ 7.7.

Boom-boom: net 91% of investors say stronger economy in 2021, majority now say it's a V-shaped recovery, 1^st time since Jan'20 investors want CIO's to "increase capex" rather than "improve balance sheet"; CPI, EPS & yield curve expectations close to record highs.

Cash is trash: FMS cash level down to 3.8%, lowest since Mar'13 (just before Bernanke "taper tantrum"); allocation to stocks & commodities highest since Feb'11; record number investors taking "higher-than-normal" risk.

Risks & crowds: investors view top "tail risks" as vaccine rollout (28%...timing of positive impact has slipped to July), taper tantrum (25%), inflation (24%); "crowded trades" are long tech (35%), long Bitcoin (27%), short dollar (13%).

Cyclical vs tactical: FMS shows cyclical consensus is "cyclical"…high exposure to commodities, EM, industrials, banks relative to past 10 years; but Jan wobble caused investors to top-up "safety of growth" exposure via tech, health care, US stocks.

Anti-Goldilocks contrarian trades: bubble move and/or big inflation in 2021 best played via FMS laggards e.g. energy & UK stocks; conversely longs in EM, commodities, industrials most vulnerable to "peak profits" narrative; either way consumer staples a smart contrarian accumulator in H1.

 

FMS cash drops to 3.8% from 3.9%, remaining a FMS Cash Rule "sell signal" (back tested 1-month S&P 500 return = -3.2%).

All-time high in investors taking "higher-than-normal" risk now at 25% in February.

FMS investor optimism on cyclical risk assets increases to net 87%, 2nd highest ever (#1 = Feb'11 - last year equity & commodity returns negative). Fund managers are heavily long while expecting inflation to pick up. 

The most recent AAII sentiment survey shows optimism rising to a nine-week high as bullish sentiment is well above its historical average of 38% for the 12th week out of the past 14 weeks. 

 

Based on the current valuation the markets subsequent 1-year returns don't look favorable. But with interest rates artificially low does this change the narrative?  

According to JP Morgan the average intra-year decline is 14% so this is expected.

Yet the market is just coming off a bear market low.

Ryan Detrick highlights how this new bull stacks up against the previous two best starts to a bull market ever ('82 and '09). This one continues to break records, but still be aware the previous two were choppy the next several months.

The chart below is a weekly chart of the Nasdaq and the lower panel is the % above or below the 40 week moving average. Historically, the Nasdaq is extended to the upside. Yet if we look at other times we have hit these levels it has more in common with the earlier stages of a bull market rather than the end. One bit of caution, most of these bull market runs have run into resistance eventually after hitting extremes and experience a deeper pullback. If we look at the 1992, 2004, and 2010 time frames it will give us an idea of what we might expect. The Nasdaq peaked roughly 10 months after the 1991 signal, 4 months after the 2003, and 7 months after the 2009 signal. Each of those periods saw a draw down of: 1991 (-15.5%), 2004 (-18.7%), 2010 (-18.7%).

Below is the ratio chart of high beta vs low volatility. When this chart is going up high beta is leading the market. Until this rolls over expect most pullbacks to be shallow and short.

In summary, sentiment is definitely stretched to the upside and most fund managers are bullish. Alone this isn't bearish but leaves me more cautious in the short term. We should expect a pullback at some point but we expect that pullback to be short, shallow, and bought. The breadth readings are more characteristic of early bull market phases rather than tops and why we don't see this market crashing. However, based on precedent we should see a bigger correction (10%+) further down the road much like 1992, 2004, and 2010. As always we'll continue to stay flexible and nimble and when conditions change we'll be ready to act.

2021 and Beyond

 

From my perspective, we are in the early stages of technological disruption and the next decade will provide massive opportunities as industries will be transformed creating a new group of leaders as innovation and efficiency puts a whole swath of companies at risk.  Cathy Wood, visionary CEO and CIO of Ark Investments, which focus on disruptive technologies, identifies five innovation platforms businesses will need to invest in or lose their way: DNA sequencing, robotics, energy storage, artificial intelligence, and blockchain technology.  This transformation is happening across the spectrum of industries from energy, health care, education, transportation, finance, entertainment, and even space exploration.  According to Tony Seba, a world-renowned thought leader, “the 2020s will be the fastest, deepest, most disruptive decade in history for energy, transportation, food/agriculture, information, and materials, with cascading effects across all sectors of the economy, cities, geopolitics and the environment and dramatic implications for humanity.”  A recent McKinsey survey published in October 2020 found that “companies are three times likelier than they were before the crisis to conduct at least 80 percent of their customer interactions digitally.  More positively, in the past, it has taken a decade or longer for game-changing technologies to evolve from cool new things to productivity drivers. The COVID-19 crisis has sped up that transition in areas such as artificial intelligence (AI) and digitization by several years, and even faster in Asia.”  According to the CEO of Twilio, “the coronavirus response accelerated the digital communication strategies by about six years for businesses.”  Microsoft’s CEO noted in April 2020 that “we’ve seen two years’ worth of digital transformation in two months.”  This once-in-several-generations change helps confirm our bias that the next decade is ripe for historic money-making opportunities.  Our strategy is well positioned to prosper from the unfolding disruption; however, we expect plenty of volatility along the way. 

 Looking Forward

2020 was dominated by the global pandemic that ushered in multiple waves of the virus, lockdowns, and a global recession.  Lockdowns drove massive amounts of unemployment and economic numbers not seen since the depression.  The policy response from central banks and governments around the world was to flood the markets with liquidity.  The Fed will maintain extremely accommodative policy into the foreseeable future which calls for the fed funds rate to remain unchanged for several years and 2021 could see a wave of additional stimulus as a new administration takes over.  One of the consequences of all the lockdowns was a spike in household savings rates.  Personal savings in the United States reached an all-time high of 33.70% in April.  It currently stands at 12.9% which is still elevated versus the long-term average of 8.93% going back to 1959.  According to Morgan Stanley, “US household are currently holding on to an excess saving of US $1.4 trillion, which equals about 9.3% of 2019 annual consumption expenditures.”

We believe 2021 will be the year of vaccines, spending, and recovery.  The pent-up demand from months of lockdowns will be unleashed as the vaccine gets distributed and the virus dies down.  With consumers flush with cash and governments spending like debt does not matter, 2021 should see a huge recovery as US GDP growth is expected to grow between 4-6%.  This begs the question: how much of this recovery is already priced in after a huge rally off the March lows which was one of the best rallies in the last 100 years?  Some data below suggests there is plenty of runway for the bull market to continue.  As stocks indices continue to make new highs and surprise to the upside, Ryan Detrick chief market strategist at LPL Financial, shows how this is bullish, he explains, “One thing that surprises many investors is that new highs happen in clusters that can last a decade or more. Given that this cluster of new highs is only seven years old, history would suggest that we don’t bet against several more years of new highs.”

 

On the other hand, in the short term, markets are certainly overheated and extended to the upside as the Russell 2000 is trading 9% above its 50-day moving average.  Sentiment among investors is getting stretched as the most recent AAII sentiment survey shows 46.1% of participants are bullish.  The December BAML fund manager survey was the most bullish all year as asset allocators are underweight cash for the first since May of 2013 as investors are overweight equities as vaccine hope induces a strong “buy the reopening” trade.  Yet, an interesting statistic from MacroOps shows the positioning chart below.  “It paints such a different picture than all the others.  It shows net commercial positioning in all major indices is positive. Meaning, conversely, that specs are still short.  This is typically more common at bottoms than tops.”

 

As COVID shows significant increases in cases, as a second surge takes hold, getting through the first quarter will be key.  With P/E ratios sitting at historically high levels, and the indices extended, we believe we could be in for a volatile first half.  However, the equity risk premium is not at incredibly low levels because of historically low interest rates.  In turn, with rates at these levels, money will be rotated away from fixed income as equites become the natural asset class to search for yield.  With the Fed willing to continue to provide support to the economy, trillions of savings on the sideline, pent up demand, and the vaccine being distributed more and more every day, the second half of 2021 should see a strong recovery.    

We prefer to stay away from predictions, especially in the short term, as we let our strategy dictate our market exposure.  In the same breadth, we believe the future remains bright for growth equities as disruption takes hold.  As active managers, our smaller size allows us the flexibility to change our exposure levels with more ease, which is critical for extracting alpha for our partners.  We believe our methodology protects our partners’ capital through various cycles. We will continue to focus on surprising to the upside as we execute our strategy.  WCP has more capacity and we are accepting new contributions the first day of every month.