Beware of Euphoria in US Stocks?
Mom and pop are rushing back to risk. The ultra-rich want in. Positioning in bellwether mutual funds has virtually never been so bullish. This as the S&P 500 has surged 11% in less than three months.I agree with O’Rourke, looking at the S&P 500 ETF (SPY), I can't see anything at the moment that will end this powerful rally, at least not in the near future:
Word is getting around about stocks, music to the ears of anyone who sells or manages them. But if you’re the type of market contrarian who thinks a better backdrop for gains is gloom, all the elation is worrying.
“Investors jump on momentum and ride the rally and then become convinced that it’s going to continue forever,” said Aron Pataki, a portfolio manager at Newton Investment Management, which overseas about $62 billion in assets. “Typically, there is euphoria before pullbacks.”
Not that enthusiasm isn’t warranted. The S&P 500 is up 30% this year with dividends. People who stress about euphoria can sound like they’re complaining about a rising market. It’s just that over the long term, enthusiasm hasn’t been the fuel that drove U.S. equities to a $25 trillion bull run.
The latest survey of fund managers from BofA Global Research showed “the bulls are alive,” according to a Dec. 17 report. Expectations for global economic growth jumped the most on record, while investor allocations to equities rose to the highest level in a year. Meanwhile, the firm found cash levels among those surveyed are the lowest in six years.
A December analysis of institutional investors from RBC Capital Markets also showed optimism flowing over. People describing themselves as “bearish” dropped to 15%, the lowest level since the third quarter of 2018, before the rout that sent the S&P 500 down 19.8%. At the same time, the ranks of bulls swelled, creating the largest gap between optimists and pessimists since RBC began collecting the data.
“The bulls have broken out and the bears have gone into hibernation,” wrote strategists including Lori Calvasina, the firm’s head of U.S. equity strategy. “If the market keeps grinding higher in the very near-term, these are likely to be important sign posts that will eventually help mark the top.”
Positioning among tactical mutual fund investors is nearing extremes. Jason Goepfert, the president of Sundial Capital Research, tracks the Rydex family of funds, and traders who use the products “have almost never been more bullish,” he says. In fact, a composite reading of different Rydex positioning measures ranks in the top 4% of all readings over the past quarter-century. Market watchers have followed the so-called Rydex Ratio for years, since the funds reported their asset levels and their clients actively trade.
Still, Goepfert notes that the signal isn’t as strong as it used to be, since investors have migrated to exchange-traded funds. But Bloomberg Intelligence data show burgeoning bliss across the $4 trillion ETF industry, too. All year long, flows into fixed income ETFs have trumped those into equity funds. That is, until now. In the fourth quarter, stock ETFs have taken in $75 billion, more than two times the amount that’s entered bond funds.
“Tons of our ultra-high-net-worth clients are calling and saying: I missed this, how do you get me in with low risk?” said Matthew Peron, chief investment officer for City National Rochdale, which oversees roughly $40 billion. “You are seeing some froth.”
Again, some optimism is far from indefensible. Global economic data has shown signs of bottoming and a strong U.S. labor market should keep consumers spending. The Federal Reserve has vowed it’s on hold after three 25 basis point rate cuts this year, and is expanding its balance sheet by the week. Bloomberg Intelligence strategists led by Gina Martin Adams don’t see the latest run as the kind of doomed, over-heating melt-up that should elicit worry.
In those kinds of spikes, optimism usually separates from fundamentals, and sentiment drives returns. But corporate profits are expected to rebound next year and the S&P 500’s cyclical adjusted earnings ratio, a valuation multiple based on 10-year earnings also known as CAPE, “may point to improving equities’ value in coming years,” Martin Adams said. The S&P 500 average daily returns and volatility are a little too low to panic over, she added.
Underneath the headline index level, however, more froth is visible, according to Michael O’Rourke, JonesTrading’s chief market strategist. Since early October, 72 companies in the S&P 500 have rallied more than 20%. Tesla Inc. has surged more than 60% over that same time period. Semiconductor company Qorvo Inc. has too, while Apple Inc. has added $225 billion in market-cap -- close to the equivalent of Coca-Cola Co.
“That’s how I know there’s euphoria out there,” O’Rourke said by phone. “The problem is, because of the mechanical nature of the market, I can’t say that this is the end of the move.”
Yes, the weekly RSI and MACD are approaching extremes, but it's hard going bearish on US stocks when the Federal Reserve has openly stated it won't raise rates unless it sees "persistent and high inflation" and is injecting massive liquidity into the global financial system in the form of quantitative easing (even if Fed officials are not calling it that).
In fact, I agree with those who think over the past decade the most effective piece of investing advice has been contained in this very simple aphorism: 'Don't fight the Fed'. If you followed that advice and ignored everything else, you have likely done well:
Sooner or later the Fed will stop creating huge amounts of liquidity and the market will struggle but apparently that isn't going to happen in the last few weeks of 2019.Clearly the rally in equities over the last few months is correlated with the expansion in the Fed balance sheet? I think it's safe this is the understatement of the year, perhaps decade.
According to Morgan Stanley, the Fed balance sheet will increase by $60 billion per month through the end of the first quarter of 2020.
This is the not-QE that Fed Chairman Powell announced earlier this year.
Here is a chart of the Fed Balance Sheet:
Clearly the rally in equities over the last few months is correlated with the expansion in the Fed balance sheet. There doesn't appear to believe that there is any reason for it to abruptly end at this time. In fact, Morgan Stanley has stated that the current market rally "may be more due to the [Fed] balance sheet reversal than fundamentals,"... but with $60 billion/month scheduled through Q1, "we think this presents a powerful positive force that can take stocks well above fair value between now and then."
This is not a complicated argument. The Fed is the most powerful force in the market and it is going to continue to provide liquidity. There are few places for that liquidity to go but into equities.
At some point that balance sheet will contract and it will make it tough for equities but that is not something that we have to worry too much about right now.
The Fed and other central banks are throwing everything but the kitchen sink to force investors into risk assets trying to inflate assets as much as humanly possible in hopes of raising inflation expectations and avoiding a protracted bout of global deflation.
Will this strategy succeed? It seems like it's working but as I keep telling my readers, the Fed and other central banks do not control inflation expectations, they control the short end of the curve and they sure can stir up asset inflation in risk assets like stocks and corporate bonds:
Clearly, stock and bond investors are paying close attention to the Fed's balance sheet and cranking up the risk this quarter.
Interestingly, over the last month, Healthcare (XLV), Technology (XLK), Energy (XLE), Financials (XLF) and Consumer Discretionary (XLY) are all doing better than the overall market while traditional defensive sectors like Utilities (XLU), Staples (XLP) and Real Estate (XLRE) which move with bond yields are lagging the overall market:
And a lot of the juice in the healthcare stocks has come from biotech stocks (XBI) which are ripping higher in this RISK On environment:
But while the euphoria in US stocks is unnerving many investors, the truth is it might continue into Q1 of next year and possibly beyond that.
Earlier this week, Shawn Langlois of MarketWatch wrote an article on how the ‘ultimate smart money indicator’ is signalling a big move in the stock market by the end of the week:
Look out, above!Indeed, there are other risks but investors don't seem to care about them as long as the Fed is pumping billions into the financial system.
S&P 500 index monthly options expire this Friday, and Erik Lytikainen, longtime trader and founder of Viking Analytics, says that, just like this time last year, investors could be in store for some real fireworks.
Just not necessarily the bearish kind we saw in 2018.
“Last December, in and around the final option expiration of the year, the S&P 500 fell by nearly 300 points,” he wrote Wednesday in a post on RealInvestmentAdvice.com. “This dramatic decline coincided with a spike in market gamma. It is my view that this decline was furthered by forced selling by the put sellers who needed to sell the S&P 500 index to cut their losses.”
Without getting too deep in the weeds, gamma measures how much the price of an option accelerates when the price of the security it is based on changes. Lytikainen describes the study of gamma as akin to the study of market risk.
When gamma is high, risks are high. When it’s low, risk is low.
“The study of market gamma can be viewed as the ultimate smart money indicator,” he said, adding that this particular measure of smart money, as this chart illustrates, suggests we could be seeing the inverse of the market declines last year:
Lytikainen forecast that instead of the put option sellers feeling the pinch in 2018, call sellers could dictate the market’s next big move.
“While I am not saying that stocks will melt up through the remainder of the year, the possibility of that scenario playing out is looking more likely,” he said, pointing out that if this were to happen, the S&P 500 would enjoy a 100-point rally in a matter of days.
“Of course, there are other market risks such as China trade and impeachment proceedings,” Lytikainen said. “I will either be watching from the sidelines, or perhaps buy a straddle to profit from a big move in either direction.”
Meanwhile, there’s a calm before this predicted storm, with the Dow DJIA, (DIA), S&P 500 (SPY) and Nasdaq Composite (QQQ) all mostly flat in Wednesday’s trading session.
Below, Andy Sieg, president of Merrill Lynch wealth management, joins "Squawk Box" to discuss what to expect from the 2020 markets. “You’re never going to make enough money if you have 40% of your money in bonds,” Quick said. “I have some cash so that I make sure that I have a cushion so that I’m not locked into it, but I don’t have anything in bonds.”
Someone should remind Andy Sieg and Becky Quick that despite the recent selloff, US long bonds (TLT) performed well this year, especially on a risk-adjusted basis, and when stocks get clobbered, they will soar higher from these levels:
Second, CNBC's "Power Lunch" team discusses markets with Kathy Entwistle of UBS and Scott Clemons of Brown Brothers Harriman. Listen to what Clemons says about the Fed's balance sheet driving markets higher.
Third, Charlie McElligott, managing director and head of cross-asset strategy at Nomura, and Mike Santoli, CNBC's senior markets commentator, join "Squawk Box" to discuss why "we're in a great environment to be long risk."
Fourth, David Rosenberg, economist at Gluskin Sheff, joins BNN Bloomberg to discuss why he thinks the current spread between CCC-rated credit and BBs in the corporate bond market looks a lot like mortgage spreads in 2007.
Fifth, DoubleLine CEO Jeffrey Gundlach was recently interviewed on CNBC stating he sees long-term rates marching higher as recession risks recede. Take the time to watch this interview.
Lastly, the greatest macro trader of all time, Stanley Druckenmiller, discusses his economic and market outlook for 2020, the direction of monetary policy, and the upcoming US election. He speaks exclusively with Bloomberg's Erik Schatzker in New York. Great interview, well worth listening to his views.
I wish all my readers a Merry Christmas & Happy Holidays, I'll be back next week with my Outlook 2020, so if you have any thoughts, feel free to reach me to share them. Enjoy the holiday season.
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