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Good morning. I have been looking back over my recent letters, and have noticed negative themes taking a larger role with each passing day. I am clearly not protecting well enough against one of my most characteristic and costly biases: a tilt towards scepticism and pessimism. So today, I propose to purge my system of bile by pushing all my bearish thoughts out in one go. I will then have a sparkling day off and, on Sunday, write the case for market optimism.
Have bearish thoughts yourself? Think the ones below are mad? Something to contribute to Monday’s column on reasons to be bullish? Email me: firstname.lastname@example.org
The bear case on the stock market
The US stock market looks very expensive on every historical metric anyone can think of, except one (earnings yield on stocks minus the real yield on long Treasury bond, on which earnings look so-so; more on that on Monday). And stock market corrections tend to happen when stocks are expensive.
But timing stock market corrections might well be impossible. Some smart people think it can be done (Jeremy Grantham, for one), but it is not easy. You can miss years of good returns waiting for the crash, and more years of good returns after the crash, should you fail to reinvest promptly. High valuations are enough for a bear case.
So what nasty observations can we pile on top of high valuations? Right now, I can think of four big ones. One, recent heavy money flows into equity funds, particularly from retail investors, can’t go on forever, and so they won’t. Two, risk appetites are clearly declining, even if it is hard to see it in the performance of the broad indices. Three, there is lots of leverage in the system, which will unwind quickly when the momentum shifts. Four, the fundamental factor everyone looks at first — earnings growth — is losing steam.
Start with flows. Previous letters have covered the record setting flows into equity mutual funds and exchange traded funds this year, driven largely by retail investors. In recent days flows have remained strong — but perhaps not quite as strong as before. The team at Vanda Research note that after every significant drawdown in the the S&P 500 this year, retail investors have lept in, using ETFs to buy the dip. But this effect peaked with the July drawdown, weakened significantly in August, and then weakened again in the last week or so:
The decline in risk appetites is visible in the weakening momentum in all but a few very popular stocks. Here, from Bloomberg, is the S&P 500 plotted against the number of its constituents that are above their 200-day moving average:
The index rises, but the effervescence is less and less broad-based. Why see this as a measure of risk appetite (it is usually described as a “technical indicator”)? Because it shows that there is a smaller and smaller number of stocks that investors are willing to bid up; exuberance is receding, capturing a declining number of stocks.
Similarly, here is the index charted against the number of its constituents hitting three-month highs:
You can also see how the market is growing thin — being held up by just a few favoured names or themes — in the index’s recent performance broken down by sector. Since May (when market leadership started to thin out as illustrated in the last two graphs) the meat of the good performance of the S&P has been accounted for by four more or less defensive sectors: technology, real estate, telecoms and healthcare. The other, mostly cyclical sectors (financials, consumer goods, industrials, materials, energy) have all posed low single-digit or negative returns.
Debt in the system? Here, from the financial regulator Finra, is the amount of US margin debt, which has soared above its pre-pandemic high. A reversal of that pattern (which may have already begun) implies selling pressure.
On corporate earnings, this chart from Citigroup’s Tobias Levkovich tells the tale well. The great majority of analysts’ earnings forecast revisions for S&P 500 companies remain positive. But the share of revisions that are positive is no longer increasing. In other words, the news is still good — but it’s not getting better any more. Only financial stocks and tech stocks had a higher proportion of upward revisions in the latest months.
Let’s sum up. Stocks are very expensive (except relative to bonds). Mutual fund and ETF flows seem to be decreasingly responsive to buying opportunities. Fewer stocks and fewer sectors are contributing much to the performance of the index. There is a lot of margin debt in the system, waiting to be unwound. And the news on corporate profits, though good, looks ready to plateau.
One more piece of key context: everyone has made a boatload of money in stocks over the past decade. What is happening, fundamentally, when stock markets fall? Investors are deciding they are happy to have more cash in their portfolios, relative to stocks. After a great run, and with inflation fears subsiding a bit, doesn’t a little more cash sound OK?
This is just an intellectual exercise, of course. But I hope it scared you a little, so you will enjoy Monday’s letter all the more.
One good read
The Democrats want to cut taxes on the (Democratic) rich.
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