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Passively Aggressive






The hallmark of passive-aggressive behaviour is often an avoidance of conflict. It's often a coping mechanism for people who are afraid to directly confront the truth. The self-denial of one's true feelings and the inability to confront them leads to dysfunction and hurt feelings.


A widespread consensus is now forming around a mild recession and a peak in inflation that will lead to a concomitant end to monetary tightening. Equities have consequently rallied into the final quarter of a dismal year. Fund flows, until just recently, have been strongly positive despite the caution most have expressed in sentiment surveys. It's like investors are doing one thing but saying another. Why are they seemingly in investment denial?


The narrative driving this recent rally is the expectations of the imminent end of the hiking cycle. The peak in the leading inflation indicators such as commodities and real estate has created a surge in investment flows as a FOMO-driven mentality reasserts itself yet again. Like a safety valve, a pavlovian 'catch the lows' response has driven investors off the sidelines. Stocks are also responding to the lower long-end yields that have been generated from this peak-inflation mentality.


I think they are in denial. I think they are getting it wrong. But they can't help it - they are being passively aggressive.


There is no time in history that investors have made money in risk assets during a yield curve inversion, especially the biggest one in 35 years! Despite this, equities seem to be priced for a recovery that has yet to occur. The forward multiple for the S&P 500 is above 17x. The equity risk premium has dropped like a stone (chart below). Why all the optimism?




Chart: J Aitykens, TD Securities



The primary reason for this high multiple is the dominance of large-cap Growth stocks, namely, AAPL, MSFT, AMZN, TSLA and META, all of which sport multiples ranging from 25X to infinity. Collectively they have distorted the 'valuation' norms, sending a signal of equity risk-taking that doesn't fit the narrative.


The source of this seems to be a mechanistic adherence to the way savings are being managed. This is a megatrend that is seemingly impervious to the narrative or the evidence of increased risk. Passive investments are now dwarfing the active investor base to such a degree that the market is sending erroneous signals to investors. Can anybody tell from this chart if risk appetite, despite the bearish sentiment expressed universally this year, has diminished recently? I can't. And since this chart was drawn, there has been another $100bn jammed into large-cap U.S. ETFs.



U.S. Equity Fund Flows


Not all stocks are similarly expensive. In our domestic market, stocks have maintained a 'normal' valuation advantage over bonds (chart below). Without the mega-cap effects evidenced in the U.S., our stocks, although not 'cheap', offer sufficient compensation for risk, especially given the better eps momentum we have experienced lately. But we are slavishly being held hostage to the U.S.-centric narrative that dominates the global investment process. Risk-takers the world over take their cue from the S&P 500, sometimes at their peril.



Chart: J Aitkens, TD Securities



Unfortunately for most investors, U.S. large-cap assets have a dominant position in their asset mix simply due to their sheer size. In the largest global portfolios, they represent all-time high exposures especially given the strength of the U.S. dollar. Like a dog chasing its tail, passive strategies are actually enhancing the risk-taking behaviour of investors the world over without them realizing it. These approaches are pro-cyclical and have distorted the 'message of the market' to a degree I have never seen.


The fever may be breaking this week as an overbought market is facing a flow of data that could generate a reaction. Last week, I pointed to the coiled springs. Unfortunately for the bulls, their U.S. large-cap equity spring has already sprung. Apple is now rolling over after a sharp bounce. Should we get data that supports the 'peak inflation' narrative, the overbought market will most likely 'sell the news'. Should we get data that calls the Fed pivot expectations into question - look out below!


Hiding out in defensive equities and mid-term bonds with a bit of dry powder seems prudent still. I see no rush to buy the China re-opening story either. Despite the hopes of a post-covid China rebound, I see the direct support of the real estate market by the government as pushing on a string. President Xi's policies of 'Common Prosperity' are unlikely to include the now-vilified Chinese equity investor. Deglobalism took another step this week with the exit of Volkswagen and Honda from the Chinese domestic market. And have we forgotten our own experience with the post-Delta re-opening false-start debacle so soon? "Short covering" is all I need to explain the China equities response so far.


Don't look too much further than the out-sized effects of passive investment flows in the U.S. equity market for an explanation of the dichotomy of rising stock prices and falling long bond yields.


The passive investor has become too aggressive for my liking.


Risk Model: 3/5 - Risk On


Although we have been skeptical of the Model's bullishness recently. I have been grudgingly in agreement that the positioning/sentiment rally is a valid construct that supports the bounce in risk assets recently. Unfortunately for investors (as opposed to traders) the positioning 'push' is about to meet the data 'shove'. The sharp drop in Copper/Gold is a definitive rebuke and non-confirmation of the China reopening story (chart below). This Friday's employment data point is looming large in my view as it has the potential to generate an outsized response. When the cost of insurance drops and there is a storm brewing, it behooves one to take out a policy. Buy UVXY as a bit of insurance in case this week is actually the real 'Black Friday' for investors.



Copper/Gold


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