Some critical observations on investor positioning from BofA's Michael Hartnett
* * *
On April 28th the current bull market in the S&P500 will become the 2nd longest ever
3 observations:
1. Quantitative Success on Wall Street
The bull market has been driven by Policy & Positioning. In Mar’09 the long-run return from US equities had fallen to its lowest level since 1940…the “humiliation” of equities was complete (Chart 2). Policy makers panicked and have been panicking ever since: QE, ZIRP, NIRP, 629 global rate cuts, central bank purchases of $11 trillion of financial assets, $9 trillion of global government bond currently yield < 0%, and so on. And it’s worked wonders for asset prices
2. Quantitative Failure on Main Street
But the long equity bull market, in contrast to the bull markets of 1949-1956 & 1990-2000, has not coincided with, nor has it led to, a strong expansion in economic activity despite unprecedented monetary stimuli. Government bond yields remain at deflationary levels. And while the bull market has been aided and abetted by corporate profits, doubts as to further gains via cost-cutting & financial engineering, and stubbornly low productivity growth, mean the absence of recovery on Main Street has in recent quarters started to weigh on risk assets, particularly since the Fed ended QE3 in Oct’14 (annualized returns of 0.8% for stocks and -1.5% for HY bonds since Oct’14 are a far cry from 20% & 18% respectively between start-QE1 and end-QE3).
Our progressive shift in recent years from “raging bull” to “sitting bull” to “volatility bull” reflects low probability of Higher EPS & Lower Rates in coming quarters (Chart 3). Plus politics promise higher taxation, higher wages, protectionism and less freedom of capital & labor movement, policies which may (or may not) reduce inequality & raise inflation, but have not historically been associated with higher corporate profits.
It’s hard to solve inequality with higher asset prices. We thus remain “long Main Street, short Wall Street” thematically.
3. Humiliation & Hubris
The most bullish argument for commodities today is “humiliation”. Similar to stocks in 2009, the rolling return from commodities is currently at a multi-decade low, indeed the lowest since 1933. And commodity producers and Emerging Markets at least offer the potential for lower rates and higher EPS over the mediumterm.
The secular upside for commodities is thus greater than downside. We like gold.
But great, historic bull markets tend to start with humiliation and a famous catalyst:
- Bond bull 1981-2016: “Volcker shock” & US/UK “capitalist” regime change
- Equity bull 1990-2000: fall of the Berlin Wall
- Commodity bull 2001-2008: 9/11 terrorist attack & China WTO accession
- Equity bull 2009-2016: QE-shock
Sustained commodity outperformance thus requires a secular catalyst and today that would need to be an inflation-shock (energy was the best performing equity sector, and only value stocks & small cap stocks outperformed commodities during inflation/stagflation of the 1970s.
* * *
I’m so Bearish, I’m Bullish!
YTD global asset returns: oil 17.6%, gold 15.7%, bonds 6.0%, stocks 1.9%, US$ -3.8%.
Investor sentiment in recent months has shifted from the “end of the oil age” to the “end of the world” to now the “end of volatility” (the VIX index and the MOVE index currently at lowest level since Dec’14).
Policy panic in Feb/March meant the Fed, PBoC, Saudi & ECB removed or at least postponed the two great “tail risks” of 2016: rate hikes by the Fed & FX devaluation by the PBoC. The absence of Fed hikes & CNY devaluation nullified the widely anticipated “default event” in EM, commodities, resources and extremely cheap, oversold “distressed value” rallied hard. And the latest in a series of “pain trades”, long renminbi-short volatility, has proved extremely painful (Chart 6).
The risk positives in Q2:
- Cash. It’s high (5.4% institutional, 12.0% private client) & looks excessive relative to redemptions.
- China. It’s temporarily accelerating.
- US. Growth has to pick-up from the embarrassing Q1 showing of “flat”, and PMI’s indicate it will do so.
Risk negatives in Q2:
- Consumer. US consumers continue to save rather than spend…small business confidence (SBOITOTL on Bloomberg) has decelerated sharply.
- Fed. Should US GDP/consumption bounce, Fed back in play, vol jumps and/or fears resurface of ”credit events” in commercial real estate, private equity, auto lending, unicorns, private infrastructure...
- Dollar. Weak dollar good but hard to see dollar decline significantly from here (i.e. DXY<90) without a negative event (US specific "credit event", political volatility, renewed plunge in ISM).
- BREXIT. Vote is June 23rd.
We believe fresh risk upside requires unlikely combo of higher bond yields & lower dollar (note the quite stunning fact that YTD global government bonds annualizing strongest returns since 1986 – Chart 7). The long-end needs to sell-off to sustain risk-rally. We also believe Wall Street fragility is entrenched by regulation, redemptions & financial repression. The “pain trade” punishment will continue.
Our “Japanification” theme argues for big, fat, volatile trading ranges being the norm. The rallies (Japan rallied +20% every year during the 1990s (Chart 8) and the fades are always driven by Policy (panic & complacency), Profits (troughs & peaks in PMI’s) & Positioning (fear & greed). As bulls begin to dominate, confidence in the macro improves & the Fed starts to talk-up prospect of rate hikes, we would use Q2 to add to volatility exposure.
The Über-Barbell of 1999 & 2016
The best bull case for risk in coming quarters remains a repeat of 1998/99. In other words, the recent “aggressive” global policy response, as was case in Oct’98, represents the last chance to buy for 4-6 quarters.
It could simply be 1998/99 all over again. After all, a “speculative blow-off” in asset prices is one logical conclusion to a world dominated by central bank liquidity, technological disruption & wealth inequality.
Back then, as could be the case today, a bull market & a US-led economic recovery was rudely interrupted by a crisis in Emerging Markets. The crisis threatened to hurt Main Street via Wall Street (the Nasdaq fell 33% between Jul-Oct 1998, when LTCM went under). Policy makers panicked and monetary policy was eased (with hindsight unnecessarily). Fresh liquidity combined with apocalyptic investor sentiment very quickly morphed into a violent but narrow equity bull market/bubble in 1998/99, one which ultimately took valuations & interest rates sharply higher to levels that eventually caused a “pop”.
What are the signals to watch for? As in 1998/99 post the easing you need to see a. US consumer strengthen in next 6 months, b. US resume tightening in due course, c. lower oil will provoke better macro data; d. M&A, buybacks, IPOs, financial engineering will be positive for stocks; e. worsening market breadth.
What worked back then? What rose from the rubble of 1998? How would one position for one final melt-up on Wall Street? Table 2 illustrates it was an “überbarbell” of über-growth stocks (e.g. internet) and über-value (e.g. EM/Russia) that massively outperformed in 1998-99.
Why? Because 1999 started as a year of “max liquidity, scarce growth & distressed value” and ended with an internet bubble causing a significant rise in interest rates, growth & inflation.