The Real Risk in the Stock Market?

Alex Rosenberg of CNBC reports, The strange dynamic that’s guiding stocks higher:

The S&P 500's surge past the 2,000 level this week for the first time ever is just the latest milestone for the great rally that stocks have enjoyed over the past 5½ years. But Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, doesn't think the latest splashy market headlines will do anything to bring in the many retail investors who have long been staying on the sidelines.

Individual investors are "still nervous, they're concerned," Silverblatt said on CNBC's "Futures Now" on Tuesday. "Even though we're into this rally over five years now, and they're getting very little if they're sitting in a bank or some alternatives, they are not moving back into the market." And he said the S&P's crossing of 2,000 won't lure retail investors.

After all, many small investors will not soon forget the market collapses of 2000/2001 and 2008/2009, which robbed them of their confidence in stocks. And in fact, the S&P has taken more than 16 years to get from 1,000 to 2,000—yielding a mere 6.2 percent annualized compound return, including dividends, from then to now.

So if that's the case, what explains the market's drumbeat of new highs? Silverblatt looks to the other key group in the market.

"On the other side you've got institutions, who are sitting in the market. They're reallocating somewhat, but they're not pulling out. These institutions appear to be more concerned with missing out on potential gains than the market declining."

"Both of these groups are just sitting tight," Silverblatt added. "And the market, in between, has taken small steps upward."

So what will shake the confidence of institutions or the reticence of retail investors?

"I'm not sure what kind of event, ... but it's going to be major," Silverblatt said. These two groups are "really difficult to move."

I'll tell you what I'm positioned for, a major melt-up in stocks, especially in biotech and social media sectors, which ironically are the two sectors Fed Chair Janet Yellen warned about. There will be a few more corrections along the way but they will be bought hard as we're fast approaching the "Houston, we have lift off!" phase of another historic parabolic move in stocks that will likely be the Mother of all bubbles.

Why am I so sure? Because there is unprecedented liquidity in the global financial system and the European Central Bank (ECB) is getting ready to crank up its quantitative easing to counter low growth and slowing inflation. Never mind Fed tapering, the baton has been passed to ECB President Mario Draghi, and there is plenty of liquidity to drive risk assets much, much higher.

And that scares the hell out of institutional investors, especially nervous hedge funds that are turning defensive on concerns over asset prices:

Equity long-short managers cut net exposures on average to 40%-45% from 50%, said Anthony Lawler, who manages portfolios of hedge funds at GAM.

Some managers are also using put options—the right to sell at a predetermined price—to protect against market falls, taking advantage of what some investors say is low pricing in these instruments.

Anne-Sophie d'Andlau, co-founder of Paris-based investment firm CIAM, bought puts at the end of June, citing market nervousness over the timing of a rise in U.S. interest rates and possible "negative surprises" in the European Central Bank's review of euro-zone bank assets, which is set to be completed later this year.

Ms. d'Andlau, whose fund is up 12.3% in the year to the end of July, said she was "not so confident on the direction of the market."

"Our analysis is that the current environment is more unstable on a macroeconomic level," she said. "You're buying puts for almost nothing."

Pedro de Noronha, managing partner at London-based Noster Capital, which runs $100 million in assets, has owned default protection on emerging-market sovereign debt for some time but recently sold some stocks and is holding more cash. He said he wanted "to make sure I have dry powder for a tough September/October. I see the market as offering very little value, and this is one of the times where the opportunity cost of sitting on the sidelines isn't so big."

But while funds have generally reduced their bets on rising prices, few believe that markets are in a speculative bubble such as the dot-com boom of the late 1990s, which preceded tumbles in stock markets.

"This isn't a greedy rally," said Chris Morrison, portfolio manager on Omni Partners LLP's Macro hedge fund, which made 5.8% in July as a call against U.S. small-cap stocks paid off. "I don't see people high-fiving. They're not saying 'get your moon boots, this stock is going to the moon.' It has been driven by a desperate need to earn a return."

This isn't a greedy rally? Maybe not but check out some of the monster moves in the biotech sector which are worrying some market watchers, and you'll see the beginning of the next major bubble brewing. And wait, Janet Yellen hasn't seen anything yet. By the time it's all over, she'll need a bottle of the next anti-anxiety biotech breakthrough to calm her nerves.

But be careful with all this bubble talk on biotechs and social media stocks. I happen to think we're at the cusp of  a major secular uptrend in these sectors and talk of bubbles just scares many retail and institutional investors away. I see plenty of great biotech stocks that have yet to take off and Twitter (TWTR) remains my favorite social media stock (it can easily double from here).

Which biotechs do I like at these levels? My biggest position remains a small cap biotech, Idera Pharmaceuticals (IDRA), a company that has revolutionary technology that is grossly underestimated by the market. But there are others I like a lot at these levels like Biocryst Pharmaceuticals (BCRX), Catalyst Pharmaceutical Partners (CPRX), Progenics Pharmaceuticals (PGNX), Synergy Pharmaceuticals (SGYP), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX),  XOMA Corp (XOMA).

The thing with biotech is there is a lot of hype which is why it's best to track the moves of top funds that specialize in this space. For example, Perceptive Advisors' top holding is Amicus Therapeutics (FOLD), a stock that has taken off in recent weeks. The Baker Brothers which focus exclusively on biotechs made a killing when InterMune (ITMN) got bought out by Roche for a cool for $8.3 billion earlier this week. I track their portfolio closely but be careful as all these biotechs are very volatile.

Big pharma is hungry for the next big blockbuster drugs. Just like big hedge funds, they are large and lazy, so they'll be looking to gobble up smaller and more productive biotech players which are actually discovering amazing drugs which are more specific and have less side-effects.

But it's not just about biotech and social media. The big deal earlier this week was Burger King's (BKW) acquisition of Tim Hortons (THI), sending both stocks way up. Hedge fund manager Bill Ackman, who runs Pershing Square Capital, had a huge payday on Monday, cementing his top spot among large hedge funds this year.

And maybe there won't be any parabolic move in stocks, just a slow, endless grind up. One pro who appeared on CNBC earlier this week said we're only 5 years in a 20-year bull stock market:

As the S&P 500 topped 2,000 for the first time Monday, Chris Hyzy said that the stock market is just five years into a 20-year bull market.

"I know it sounds easy to say," U.S. Trust's chief investment officer said on CNBC's "Halftime Report." "When you really think about this, this is an elongated business cycle. You're going to have fair value through most of it. You're not going to get a lot of overvaluation."

Hyzy identified what he saw as key for the continued bull market.

"You're going to have some very big opportunities inter-sector and themes. M&A is running wild. But the key to all of this is the manufacturing in the next decade," he said. "It's already happening. You've got energy independence on its way. The private sector's piercing through whatever restrictions are being put out there, and you've got technological advancement that we haven't seen since the early 1990s.

"That sets us up for an elongated business cycle, which is about five years into a pretty long secular market."

Hyzy, who expects GDP growth of 3 percent to 3.25 percent for the United States this year, said that he liked the financial sector best of all, with selected technology and oil-service plays.

Europe, he added, resembled Japan at the outset of its 20-year deflationary spiral. With credit growth contracting, weakness in Germany and French bond yields below that of the U.S., European Central Bank President Mario Draghi "has to act at some point, and it's a little too late."

"I would argue that the first movement on QE in Europe is a good thing for low-quality assets," Hyzy said. "You'll get the big rally. And then you'll levitate for a while if growth doesn't get there."

Are we only 5 years into another 20-year bull cycle? I doubt it but with bond yields at historic lows, stocks are the only real game to play but you have to pick your spots right or you won't make money.

That's why it's increasingly important to really drill down and understand the portfolio moves of top funds. Ignore Goldman Sachs' top fifty stocks hedge funds are shorting like crazy or the top fifty hedge funds love the most. Most of the time, you're better off taking the opposite side of these trades, and the Goldman boys don't tell you the top fifty stocks hedge funds should be buying going forward (like Twitter!).

There is a lot of garbage out there, stock market porn, and it's no wonder very few retail and institutional investors make money actively managing their portfolios. And it's not just about picking stocks right, you got to get the macro calls right, which very few people seem to be doing.

Just yesterday, I watched and interesting interview with Ambrose Evans-Pritchard posted on Zero Hedge (see below). I agreed with him that the U.S. will remain the economic superpower over the next century but was baffled by his call that rates will rise because "wage pressures" will pick up significantly.

I've said it before and I'll say it again, after we get a huge liquidity driven spike in stocks, we'll see asset prices across public and private markets deflate and a long period of deflation will settle in. There is simply too much debt out there and it won't end well (listen below to Chris Martenson's interview with Hoisington's Lacy Hunt to understand why).

But remember the wise words of John Maynard Keynes, "markets can stay irrational longer than you can stay solvent." The events I'm describing above won't happen in the next year or even five years. So while the Zero Hedge bears keep posting scary clips, relax and mark my words, the real risk in the stock market is a melt-up, not a meltdown, and institutions betting on another crash will get clobbered.