Many stock market observers focus on “fundamentals.” They eagerly scrutinize the latest economic report or company earnings results. Market participants quickly (over)react to the latest news. Yes, the economy and corporate profits are important to future returns, but investor psychology is even more important, and it varies tremendously. For a given set of fundamentals, the interpretation is either rosy (the usual bias by pundits and the media) or dire (usually at the bottom of an economic or market cycle). Market prices swing like a pendulum between the driving emotions of greed and fear. And that creates mispricing, which is what we patiently look for.
Current Market Fundamentals
Fundamentals are weakening rapidly. The exuberance over the “reopening” of the U.S. economy last spring and the boost to consumers from massive federal government spending was unwarranted. Massive consumer spending during the pandemic on durable goods – several years’ worth – pulled forward demand that would have come later.
As this has become apparent, consensus forecasts for third-quarter GDP growth have plummeted over the past three months, and forecasts for corporate earnings are likely to follow. Demand is weakening in many sectors, while costs are rising. An additional concern is that China’s economy, the world’s second largest, is stagnant, and its massive real estate sector is in deep trouble.
Investor Psychology and Positioning
Investors have been overconfident for years (with few exceptions). Surveys to discern how investors feel are useful contrarian market indicators, but it is even more important to see how investors have positioned their portfolios. Are investors “fully invested bears,” nervous about a decline but who have yet to sell? It seems so. Despite surveys that show concerns about a near-term market decline, portfolios are positioned quite aggressively. Institutional cash levels are at record lows, and stock holdings by individuals – including stocks bought on margin with borrowed money – are at record highs.
The market is extremely vulnerable to a shift in mood. The massive shift to owning index funds rather than actively managed portfolios has severe implications for the next bear market. Portfolios that used to hold cash to meet redemptions have largely been replaced with those that hold no cash (index funds hold no cash). When the market mood changes and investors begin to sell, redemptions from index funds will force the sale of the underlying stocks, especially those that dominate market indexes (such as Apple, Google, Amazon, Facebook, and Microsoft).
As prices decline, there will likely be sales to repay margin debt, as well as selling by trend-following hedge funds, causing waves of additional sell orders.
Anatomy of Market Tops
There is a clear historical pattern to market peaks and subsequent behaviors. Small-capitalization stocks peak first, as investors rotate into higher-quality stocks, usually the leading technology stocks. The small-cap Russell 2000 Index peaked in March, and the S&P 500 peaked more than a month ago. (Whether this marks a major market top will be determined only with considerable hindsight.)
As prices decline, expect talk of a “healthy correction” (an arbitrary threshold of a 10% decline) of a stock market that had become a bit rich. The market could then purportedly resume its (inexorable) rise (“Buy the dip!”). When the market doesn’t sustain a rebound and prices fall further, at an arbitrary threshold of a 20% decline, pundits will declare that it has become a “bear market.” What does one do with that declaration? Once psychology turns, a market rebound becomes a reason to get out (“Sell the rally!”).
An Ailing Patient
Despite outward signs of health, the underlying condition of the stock market seems extraordinarily fragile, in part because valuations are among the most expensive on record. Market participants of all types – individuals, hedge funds, and more-mainstream institutional investors – have jumped on board as the sentiment pendulum has been stuck at “greed.” For the professionals, it has been too costly for reputations (and careers) to be too cautious late in a market mania, and they concoct reasons to justify even higher market forecasts. We’re willing to steadfastly take the other side of that trade, as our foremost responsibility is to protect our clients’ capital. There are times to buy aggressively (when the risk/return odds are favorable). We do not think this is such a time. By holding more cash than normal and continuing to buy only when the odds justify the risk, we’re allocating less to stocks until better opportunities arise. This can happen gradually – or suddenly.
Pockets of Value
There are pockets of value, however. Our favorite sectors are Consumer Staples, Telecommunications, Health Care, and Real Estate Investment Trusts. We have little in Technology, Consumer Discretionary, Industrials, and Banks (after their huge gains over the past year). We have large holdings of international stocks, which have underperformed the U.S. and have better valuations. Over the last five years, the Europe, Australia, Far East Index of developed-market stocks (EFA) is up by only 35% versus 105% for the S&P 500.
Bonds
We are more constructive about owning bonds, despite their historically low yields. A recent spike in inflation expectations has pushed yields up and made bonds quite unpopular. We think they’re undervalued, especially to foreign investors, who face much lower yields at home. Furthermore, over the long term, we expect pressure on economic growth (and inflation) in the U.S. due to higher productivity from technology investments and from the aging population (less earning and spending). Interest rates could indeed continue their 40-year declines.
Summary Allocation
In sum, we have record low allocations to stocks, are more positive than normal about bonds, and have record high allocations to cash.