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Mar 04 2021

Research Preview: A Tale Of Two Tails

  • Mar 4, 2021

Top decile valuations, such as those in place today, are usually the result of excessively positive investor sentiment that leads to inflated multiples. Bullishness comes in varying strengths: optimism, enthusiasm, exuberance, and, at the extreme, the mania of crowds. Leuthold research typically tracks valuation sentiment by examining median P/E ratios, but in this study, we are taking the opposite tack. Rather than looking at medians, we are focusing on the outliers in each tail of the valuation distribution.

Inflation fears have justifiably ratcheted higher in recent weeks. The expected inflation rate embedded in the bond market (i.e., the 10-year breakeven rate) surged off a low last March to more than 1% above the 10-year Treasury yield. Industrial commodity prices have reached their highest levels since 2011, and the price of crude oil—tripling from year-ago levels—is now higher than before the pandemic.

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High growth rates, innovation, and disruption are defining traits of the companies that have powered the market to recent highs, and the ARK Innovators Fund (ARKK) is an example of today’s enthusiasm for visionary growth stocks. Recent returns and growth in AUM have been nothing short of spectacular, and ARKK has become symbolic of today’s style of new-era growth investing.

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Just a few quick thoughts on the pending minimum-wage hike, surging bond yields, and fund flows.

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Investors have developed many short-term sentiment gauges; for example, the various surveys of individual (AAII) and professional investors (Investor Intelligence), along with newsletter writers’ recommendations. There are also measures for bullishness/bearishness based on media stories, recent market performance (e.g., Advance/Decline, New Highs/New Lows, Up/Down Volume, the total return of different stock subsets), and assorted behavioral indicators—including margin buying, short-interest, put/call ratio, CFTC futures-position changes, MF/ETF fund flows, and future stock market volatility.

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The last few weeks offer plenty of evidence that the mania has moved into a more feverish phase, yet the Fed insists that it is still “not-even-thinking-about ‘thinking about’” raising interest rates. That dismissive attitude could well whip up an even higher fever in the months ahead.

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Policy officials and the private sector devoted 2020 to bolstering future demand. Some of the fiscal stimulus was spent, but much of it was saved. Chart 1 illustrates that personal savings as a percent of GDP surged to a post-war high of 14%—more than 7.5% higher than average and 4% above its previous record high in the mid-1970s! That is a lot of future buying power!

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Greenspan initiated the “Fed Put” as an aggressive monetary action. It was stepped-up under Bernanke to direct quantitative easing and became perpetual monetary looseness with Yellen. Under Powell, it is now a “Let’s run it hot, rates will be low for a long time, Everything Bubble!”

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The Core CPI numbers are slightly below consensus. With equities at extreme valuations, having well-contained inflation is not a bad thing at all. Enjoy the “goldilocks” while it lasts.

 

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As the stock-market rally continues, there is growing concern that investor sentiment is becoming too buoyant. Several indicators suggest investors may be feeling a bit too comfortable and a bit too confident. A correction (perhaps a nasty one?) sometime this year that checks optimism and complacency is probably inevitable, but healthy for the ongoing bull market.

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Despite the amazingly quick, and surprisingly strong recovery from its COVID-19 crisis low last March, worries have escalated about the stock market. Roaring to new record highs while the pandemic continues to ravage Main Street has popularized a narrative that suggests the stock market has entered a “Manic Bubble.”

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For decades, stock market observers have viewed January’s action as a harbinger for the rest of the year. Is there any merit to that belief?  

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The January moves in heavily shorted Micro Caps were more bizarre than anything we saw during the wildest days of the Tech bubble. Despite these signs of rampant stock speculation by the retail crowd, we still wouldn’t characterize today’s sentiment backdrop as frenzied as the peak levels of 1999-2000.

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With yields on the 10-Yr. Treasury finally breaking above 1.00% last month, the consensus has quickly evolved to the view that stocks and yields can continue to rise alongside one another for a while. Small Caps have shown a decisive performance edge during the recent episodes.

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The recent months’ surge in Small Caps has been historic, and the Russell 2000 continues to register ridiculously “overbought” readings on many technical oscillators. In the short-term, that might be a cause for caution on the overall market. However (and perhaps counter-intuitively), this extreme strength cements our view that a long-term leadership cycle in Small Caps is underway. 

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Feb 05

The Redditors came for the hedge funds, and chaos ensued. We think that when the dust settles, the Reddit crowd will be the spark that allowed more powerful market players to inflect the real pain. Our thoughts, from experience, on why this happened and how we try to avoid it.

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We look at the recent short squeeze and examine how these populist movements affect the market performance in populist vs. establishment countries, and dig deeper into the regional versus sector effect.

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As new home sales skyrocket alongside plummeting mortgage rates, we revisit the historical relationship between Homebuilding stock returns and industry-specific factors that impact housing affordability and homebuilders’ bottom lines.

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Crises are dominated by macro events. When the world is collapsing and policy officials are flooding the system with juice, earnings and company specifics get lost in the shuffle! Instead, investors tend to focus more on broad asset classes. Too much in the stock market? More bonds? Cash? Gold? When markets are surging higher or free-falling, who really cares if ABC Corporation beats estimates by a penny?

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Last week was a good reminder that unexpected things could happen in the stock market at any moment. Here we were watching the daily COVID-19 news, stimulus drama, earnings reports, and wham, the “Reddit Revolution” whacks stocks and totally wipes-out a mostly accommodating January stock market. Stocks have risen so much that a correction this year seems almost assured. Maybe one is unfolding now? Even though they are emotionally challenging, investors can survive corrections with a little fortitude, an eye to the future, and diversification. The real concern is whether the stock market is vulnerable to a “cycle-ender?”

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We’ve read far too much about what Joe Biden and a newly-blue Congress might do in the months ahead, but less so about the conditions Biden and his team inherit. Such “initial conditions” usually have a heavy hand in policy outcomes, market outcomes, and even a president’s legacy.

 

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Just purging some random thoughts that have been cluttering up the place!

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Read this week's Major Trend. 

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There are certainly many signs the stock market could be getting out over its skis and a correction may be looming. A Russell 2000 small cap index that has more than doubled from its lows last year, extremely high valuations compared to historic norms, an explosion in SPACs, IPOs, and M&A activity, several scary investment sentiment indicators, outsized and over-the-top economic policy accommodation, ridiculous recent price surges in heavily shorted stocks, and the price of Crypto going Crazy!

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Sometimes the simplest explanation is best. Most believe global economic growth will be strong this year. As vaccines work to dampen (if not end) COVID-19, massive policy accommodation, the restart of social industries, and the revival of private-player confidence and glee should boost economic growth across the globe. Added to that are strong pent-up demand and record-high savings.

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Economic programs traditionally take time to improve unemployment after a recession. However, the COVID-19 crisis created a unique divergence within the job market that will not be solved by customary economic policies, but rather, by vaccinations!

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Read this week's Major Trend. 

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Investment styles and factors are generally interpreted as having an inherent preference for either bullish or bearish market environments. The theoretical tilt of each style is based on its design and its sensitivity to economic, profit, and valuation cycles. However, theory and practice do not always agree, and we must look to actual performance to confirm our impressions.

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There are always conflicting signals surrounding the stock market. Today is no exception. Valuations are extremely high, but yields are near record lows. Recent economic reports have weakened due to the winter’s COVID-19 surge, but current vaccinations (although slow) highlight how close the U.S. is to a more extensive economic reopening.

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The CPI numbers are largely in line with expectations. A blue sweep and a new Fed regime is a powerful combination that should be taken seriously. We now believe the odds of higher inflation are materially better than just a month ago.

 

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Like the Saturday Night Live “Cowbell” skit, among policy officials and politicians, the solution to “everything Pandemic” has been, We Need “MORE Stimulus!”

Undoubtedly, the COVID-19 crisis has been a rare if not unique situation, incredibly serious, and has caused widespread and immense hardship. Due to that, we received a $2 trillion fiscal CARES package last spring, a massive increase in quantitative easing resulting in an 80% increase in the Federal Reserve’s balance sheet since last February, and a surge to an all-time-high 26% annual growth in the U.S. M2-money supply.

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As the stock market continues to surge higher in the New Year, investor anxieties surrounding excessive valuation risk are also rising. Many increasingly worry that the bull market has entered a manic bubble reminiscent of the late 1990s.

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Read this week's Major Trend. 

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Forecasting GDP is hardly our forte, but 2021 should see a very big gain in real output. Our current guess is for real GDP to grow 5% this year. Statistically, though, that doesn’t imply that the stock market’s move will also be large (or even of the same “sign”). 

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Inflation surprises have run hotter in the U.S. than in the rest of the world, no doubt reflecting the strength of major currencies versus the U.S. dollar. 

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The GS Scores handled the chaotic, 2020 market well, turning in a +10.1% return spread. The lone black-eye was November, when the Pfizer vaccine news upended quant factors and produced the worst single-day performance in GS Score history.

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The 200-day “report card” for this bull market shows the best initial-performance gain of all postwar bulls, but it’s come at a price. Investor sentiment is above levels seen at the same point of past bull markets… and there are the valuations. 

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We’ve updated our time-cycle composite for 2021 and it looks like it will be a year of “two halves,” with a low-vol bull-market extension in the first half of the year, followed by a much more volatile second half. This also appears to extend outside the U.S.

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