The Bank of America Merryll Lynch investment manager survey shows investor sentiment at extreme bearish levels with very high allocations to cash which is often a sure sign that the market has turned overly bearish and that a bear rally is eventually ahead of us. Sentiment/Positioning but maybe not Momentum tend to suggest that the worst may indeed slowly behind us. The question is what investors will settle on in this next phase of the market – surely some Tech (High Quality) eventually rallies ahead of the rest, but the vast majority is likely to prefer companies that offer Value and a stable earnings profile.
1. Preference for Low Risk/Value/Quality should remain as fear recedes
While a multiplicity of shocks may finally be closer to peaking in the markets, they are still percolating through the economy along a multiplicity of channels with different intensities and durations leading to shocks in the financial market down the road. For now, rising inflation continues to make casualties with the latest earnings disappointment of the company Target as less wealthy consumers are unwilling and unable to bear rising costs (+supply chain pressure). What we know about this phase of the business cycle historically is that fixed income underperforms, while equities have less clear patterns. As usual comparison is no reason, but it does greatly inform. Faced with such a complex environment, we should see investors choose prudence within equities especially as part of Tech/Real Estate/Art remains very expensive. One key issue is that the end interest rate both for the Fed and as the ECB ramps up are actually deeply uncertain and very hard to forecast. Will the Fed have to overtighten leading to a recession as many argue?
2. Leverage is the elephant in the room
One of the reasons the financial market hasn’t stabilized yet is most likely the elevated degree of leverage in the market. Those that can have likely borrowed for years betting on rising assets from Art to Tech and not all of them can afford the losses. For example, blank check companies (SPAC) which buy companies saw their heyday in February 2020 without much wider consequence but eventually it should affect high-end consumption, real estate et al. Such investors typically leverage through derivatives selling volatility and the enormous jump in equity volatility during March 2020 (Covid-19) is likely symptomatic of this. Slowly but steadily they surely have levered up again and part of them turned increasingly bearish and holding more prudent equity positions such as Coca-Cola or Air Liquide. Over a period of many months, higher interest rates should impact the housing market. According to Zillow, already 75% of post-subprime house buyers regret a decision to buy that was rushed and too expensive. As this market eventually cools or corrects, it should negatively impact growth and financial markets with potentially rising talk of a recession. As we transit between a bear rally and its last leg at an unknown time, a blend of styles is likely an attractive way to wait it out and move through the next phase of the market.
3. The advantage of a blend of styles
A style works well when it anticipates an economic mechanism and the fashion of the market. When we are faced with far greater economic and financial uncertainty, Low Risk/Value and Quality (when not expensive) are typically in demand. Yet, a blend of Low Risk/Value and Quality likely makes more sense removing companies that are far into the mature heading to the obsolescence spectrum. As we widen the universe of styles that are blended, the opportunity rises to catch more complex exposures that are not obvious in simple backtesting but are more through rigorous analysis. In particular, if markets sell-off you get the Low Risk protection; if inflation and yields stay high, you are less impacted by higher interest rate due to a Value exposure; and if things pick-up from here, you have great high Quality companies (with descent growth prospective) that will most likely perform too. Finally, an important feature of this is that the odds that you regret your decision are lower which is sometimes a crucial factor in periods of uncertainty.