The Missed Market
This year, many investors have missed the opportunity to fully benefit from the bull market.
Personal financial advisors have been openly sceptical of the market, saying "I'm worried about volatility"- (how's that working out for ya?) They have been consistently diverting their clients into the crowded low-vol income trade. Institutional investors have been universally dismissive of public equity markets, using backward looking, volatility based de-risking arguments to justify their increasing allocations to illiquid alternatives like real estate.
As we see below, there have been virtually no net inflows into U.S. equity funds (mutual funds & ETFs) this year. This data includes both passive and active managers. Vanguard and Blackrock have reported record inflows but are dominated by passive products. But they have only benefited from investors' massive replacement of active funds by passive index-based proxies. The net effect is zero.
(Source: Morningstar Financial)
What also sticks out is the huge bid to the bond market. This year, despite a series of Fed rate hikes and the unveiling of the "QT" plan, risk averse investors, many of them money market refugees, have been lapping up bond products like crazy. Income replacement and security of principal continue to dominate the motivations investors, many who are of the survivors of the 2008-09 financial meltdown.
Combine that with the insatiable foreign demand, and its no wonder yields are pinned to the monetary mat.
The side effects and unintended consequences are numerous. Flat yield curves, inflated valuations, massive non-financial debt accumulation and income disparity are but a few lingering legacies of the whole QE experiment. But I digress.
As Chris Harvey, head of quant strategy for Wells Fargo Securities noted last week, "Passive is the new QE".
He postulated investors in passive index products have had a chilling effect on both volatility and liquidity. That has made the market immune to Washington policy uncertainty and other global geopolitical events. Isn't that the message of the structurally low Vix?
Momentum factor leadership has resulted in a crowded trade becoming ever more crowded as passive, cap-weighted funds continue to gain market share from stock pickers. There is nobody "managing" the index funds. Who has the mandate to raise cash and rebalance this juggernaut of a bull? Corrections are the new black swans.
International funds have also gained share, justifiably, as the previously lagging Eurozone and EM recoveries gained ground. The grass is always greener I guess.
Sentiment Headfake
The only investor survey I watch is the AAII. Last week dropped it like a stone last week on the back of a sell-off in the junk bond market. These are investors who are active managers of real money. They have skin in the game. What they think says a lot about the state of today's market.
As you can see, the ratio of bulls to bears dropped sharply last week. I believe it was simply because of a 3% drops in the $HYG and $JNK. The hyperbolic coverage of this event by CNBC and Bloomberg centered on the impending doom that was being messaged by the "smart money" players in the junk bond market. Re-read last week's blog for my take on that questionable linkage.
Just when the market had started to exhibit a bullish tone, the sentiment rug was pulled out from under it by a couple of illiquid ETFs undergoing a bit of profit-taking. Oh well, these buying opportunities are usually short lived and shallow.
But given last week's immediate rush to Bonds, Consumer Staples and Utilities, it would appear the vast majority of equity players have taken this bull market off anyway. Funds are still flowing into the safety trade, years after the crisis environment that ignited it.
Mutual fund pioneer John Templeton famously said "Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
My reading is that we are still in the skepticism phase. Until bond yields rise and force people to move into the types of stocks that do more than just regurgitate income, the leadership rotation is still ahead of us. Value, and ultimately cyclical growth will need to get a play before I will get bearish. We will be keeping the torch lit for the pessimists and skeptics. They may just become born-again optimists some day.
Risk Model; 3/5-Risk On
The spike in VIX subsided after a quick end to the short sharp correction in High Yield ran out of steam. The RSI is still elevated, although below the 200 dma sell zone. Copper/Gold is bullish as the global reflation continues apace. Sentiment, AAII Bull/Bear has collapsed but I view that as temporary.
Value vs Growth
The fear of missing out (FOMO) has been replaced by FOMU - the fear of messing up ( Tobias Levkovich of Citi). This thinking will dominate markets as we head into the bonus-generating year end performance period. I expect the momentum trade, including Bitcoin, will be the winning theme til the calendar flips in January and profits can be crystallized. The value trade will likely underperform a bit longer.
Flat Yield Curve
In bonds, the strong seasonal bid is keeping the curve flatter than it should be (see chart below). Despite signs of tightening policy and strong labour markets, bond spreads are at 58 bps in 2s to 10s.
Some are questioning the relationship between domestic conditions and ten year yields. It is possible that this indicator has been temporarily broken because of the strong bid to the US bond market from Japan and the Eurozone?
The Fed is being railroaded by the stronger economic data into a series of rate hikes that could prematurely invert the curve. Will next year see a continuation of this artificially low long bond yield? Will the Fed blink and let the economy run hot? Incoming Fed Chairman Powell has big job ahead of him.
This situation could be similar to the late seventies when stagflation and a dovish Fed drove risk averse investors into fixed income just as inflation pressure were brewing. That ended badly for bondies. In time, this bond market could too.
