Are we at the market peak? (Part II)
A few months ago, we were having a conversation with a fund manager we were assessing, and he told us that he thought the market was due for a correction as it had reached an ‘irrational exuberance’ stage. We told him that we didn’t think we were quite there as we hadn’t seen the HNI investors capitulate yet (this was late summer when vaccine timelines were still unclear). Fast forward a couple months, and now, we have noticed aggressive buying, especially in high P/S stocks, in the HNI market in our part of the world. So its safe to say that they have capitulated now. Every time we see investors of various wealth levels (retail to institutional) go all in, we start to get a bit cautious and a bit curious. So when this happens, we go back to our favourite model for judging where we are in a market cycle by using Howard Marks’ pendulum framework. We like it because by asking just a few questions, we can get a rough sense of where we are in the market cycle.
You’ll notice this blog is called “Are we at the market peak? (Part II)” because we wrote a very similar piece at the start of this year, which you can read here. In that post, we concluded that the market was very close to its peak. Lo-and-behold, two months later we saw the sharpest market correction in history. Now clearly we did not predict the catalyst (global pandemic) nor the timing, so as with all such predictions, take the below with a heavy pinch of salt. That said, we do find this framework very useful in guiding our aggression/conservativeness, and we used it again in mid-March to great success.
In case you haven’t read our previous post, the exercise goes like this; Below are a number of categories where you have to choose between the “Optimistic” or “Pessimistic” option. Once you go through all of them, if you find most of your selection are in the “Optimistic” column, it’s likely that the market is getting overheated (or close to it), if it’s the other way (i.e. mostly “Pessimistic” options) then it’s likely the market is ripe for investment and there’s great value on the table. If you get a mix, then it’s likely the market is in the middle part of a recovery phase. We’re going to go through the exercise below, using data where possible and gut-feels in some areas (Hey, this is a blog post, not an academic paper!). Feel free to do the exercise yourself, you may get different answers, and that is perfectly fine. If we all agreed all the time, investing would be super boring.
Ready? Ok let’s get to it. Here are the categories:
Economy: I think this is an easy one, while the global economy is recovering, I don’t think anyone can say it’s vibrant. With travel, F&B, in-person experiences, all suffering still it’s hard to say that the global economy is vibrant. According to the IMF, 2020 will see a global GDP contraction of -4.4% and advanced economies contracting 5.8%[1]. So, we think, this one we clearly need to mark with a “Pessimistic” rating. Now, this could change quickly next year with a wide rollout of the vaccine, so watch this space.
Outlook: While certain sectors like the ones we mentioned above will take some time to recover, the outlook for the global economy in 2021 is positive, with the IMF predicting a 5.4% global GDP growth rate. While recovery will be uneven, and could take longer than expected, I think it’s safe to say the future outlook looks more “Positive” than “Negative”.
Lenders/Capital Markets/Capital/Terms/interest Rates/Yield Spreads: We’re going to take all these categories at once as they’re all quite related, and quite clear. Fed printing money, fiscal stimulus, rock-bottom interest rates, Junk bonds being priced below 3%, Greece 10year below 1%, etc. all point to the “Optimistic” column. A funny anecdote on the “Terms” category here; Anyone in Singapore will know it’s very common, sometimes several times a day, to receive texts from unlicensed bookies offering gambling services (Fun fact – Singapore has the 3rd highest gambling debt per capita[2]). Well off late we’ve noticed not only are these texts increasing in frequency, but the terms are getting more and more attractive; Zero deposit, 25% cash rebates, 30% bonuses, etc. When terms get so aggressive for some of the worst credits in the market (gambling addicts), it’s worth taking a step back and wondering if we’re getting a bit too relaxed with our lending standards.
Investors: As we discussed in this blog post, we noticed that investors of all types were capitulating and buying into the market. As can be seen by CNN Money’s Fear & Greed Index, the dial has really shifted toward extreme greed.[3] YCharts also publishes a US investor sentiment, which is as bullish as it has been since the start of 2018[4] (shortly after which the market had a 10% correction). So given these data points, it seems to make sense to mark all the Investor categories on the “Optimistic” side. (Just a quick note here, the % Bullish is around 47% on the last count, but was over 50% just a few weeks ago, so this measure shifts quickly and arguments that we’re somewhere in between “Pessimistic” and “Optimistic” are valid.).
Asset Owners: As we’ve already explored the sentiment of public market investors, for this category we like looking at alternate assets such as real estate, crypto, commodities etc. This is a tough category as there seems to be a few differences across the board. It seems like commercial property owners are still a bit pessimistic[5] where as secondary home sales, in the US, for example, are picking up nicely since April[6], with inventory falling to record low. That said, it seems like Bitcoin holders are very happy to hold (supply is set, so only way price goes up is if demand greater than supply). Overall we’ll have to put this in the ”Optimistic” column though, as it doesn’t seem like anyone is rushing for the exits right now.
Sellers: As with the above category, it doesn’t seem many asset classes are in a free-fall, which implies that buyers outnumber sellers.
Funds: This is an interesting one, as it’s really not been a great year for Hedge Funds, in September year-to-day we saw that the Hedge Fund industry had lost nearly $35bn in capital due to outflows.[7] That said, that quarter also saw the first major inflows since Q1 2018, which implies the tide is turning[8]. Although it doesn’t seem like there is a huge rush of money into funds just yet. Further BofA Bull & Bear indicator has pointed to equity flows and equity market breadth are in a neutral position.[9] Given this, and just some anecdotal evidence that funds aren’t being too discerning about letting in LPs or that funds are charging very high fees, we don’t think we’re quite at a crazy optimism stage for funds just yet. We’re probably somewhere in between “Pessimistic” and “Optimistic.,” but for the sake of this exercise we’ll pick one or the other, so will go with “Pessimistic”.
Recent Performance: Now, what “recent” means is up to interpretation, but anyway you look at it where from the start of the year or the bottom in March, it’s been a strong year. The S&P 500 is at its all-time high and up 12%+ for the year, the MSCI World index is almost at its all-time high. Considering how the year started, it’s hard not to see the recent performance in equity markets as “Strong.” Debt markets have also had a good recent performance with the S&P 500 Bond index up nearly 10% YTD[10].
Asset Prices: Ahhh, now onto controversy. By traditional measures Schiller PE, we’re about as high on valuation metrics (for the S&P 500) as we were in Jan 2018 (basically the two highest numbers since the 2000 bubble). SAAS companies are also trading at all-time high multiples.[11] However, there are some cogent arguments which highlight that due to an increase in liquidity and low interest rates, valuations aren’t as high as they may appear on the surface. This is a debate which has many sides to it, where traditional value investors will point to high multiples and irrational exuberance (i.e. in the EV space) as indicators of very high asset prices, but with growth investors pointing to the low interest rate environment as an indication that equity markets are the only game left in town. But considering this framework is put together by Howard Marks, who is a traditional value investor and recently stated that valuations in debt and equity markets were toppish, we think we’re going to have to go with “High”.[12]
Prospective Returns: Despite a decent run up in asset prices, it still seems that major sell-side analysts are predicting a rosy year in 2021, especially for equities. Goldman thinks Asia-Pacific stocks could rise 18%[13], Credit Suisse feels 2021 could see further fall in equity risk premia[14] , and Barclays thinks the S&P 500 will hit 4000 next year (up 9%) from here. Further if a vaccine is rolled out early on in 2021, it’s hard to see how many beaten up stocks in airlines, travel, live-entertainment won’t see a strong comeback. So despite potentially high asset prices, it does seem that the picture for 2021 does look pretty decent. What returns will look like after that is anybody’s guess, but for now we mark this one as “High”.
Risk: This is probably the most subjective category of them all, but we do think that if you’re sitting in a whole bunch of cash your biggest risk is probably buying too little/taking too little risk if you think 2021 returns will look good. Risk are ever present as defaults, fourth waves, a slow recovery/vaccine distribution, but these are known risks so overall risk level is somewhere in between “low” and “high.”
Ok, now that we’ve gone through each section, lets take a look at the results.
Overall about 72% of our responses are on the “Optimistic” side, whereas the rest are somewhere in between or on the pessimistic side. Further some pretty big measures, like the economy, are on the “pessimistic” side of things. This implies that while we’re probably on the riskier side of the pendulum swing (see image below, source), and we’re likely towards the “Complacency” part rather than the “Greed” part. This means that we’re not at the market peak quite yet, but if a few things change (like a rapid economic recovery), we will get close to it quickly. Just for reference though, based on this analysis (and how many categories could go either way), we think we’re further from the market peak now than when we did this exercise at the start of the year.
Now the question is what to do if you agree the market is in the “Complacency” mode? Well, first of all, this isn’t a signal to sell everything and move to cash. Not by a long-shot. This is a signal to tighten up your investment process, i.e when investing, make sure you don’t overpay or get caught up in a hype-stock/asset. It’s a time to spend that extra week or two into your analysis to ensure you’ve covered your bases, and it’s a time to de-lever if you are leveraged. It’s a time to be patient rather than greedy, as the market can oscillate quickly. Overall it is a time to carry on, just with more caution.
We hope this framework has been helpful to you in understanding where we are in the market cycle. Whether you came to the same conclusion we did, or one quite different, your judgement on the stage of the market cycle should drive your current investment decisions.
Thanks for reading, and as usual, happy investing!
[1] https://www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWORLD
[2] https://www.statista.com/statistics/552821/gambling-losses-per-adult-by-country-worldwide/
[3] https://money.cnn.com/data/fear-and-greed/
[4] https://ycharts.com/indicators/us_investor_sentiment_bullish
[5] https://www.globest.com/2020/10/27/cre-professionals-pessimistic-in-sentiment-survey/?slreturn=20201103043535
[6] https://tradingeconomics.com/united-states/existing-home-sales
[7] https://www.hedgeweek.com/2020/09/24/290080/investors-are-returning-hedge-funds-industry-enjoys-positive-capital-flows-second
[8] https://www.pionline.com/alternatives/hedge-fund-assets-regain-ground-after-losses-first-quarter
[9] https://afewthings.substack.com/p/cover-your-a-ultimate-bargaining
[10] https://www.spglobal.com/spdji/en/indices/fixed-income/sp-500-bond-index/#overview
[11] https://cloudedjudgement.substack.com/p/clouded-judgement-11620
[12] https://www.youtube.com/watch?v=YrqpMKw46ys (look at 11:25 mark)
[13] https://www.cnbc.com/2020/11/17/goldman-sachs-predicts-18percent-total-returns-for-asia-pacific-stocks.html
[14] https://www.credit-suisse.com/microsites/investment-outlook/en/investment-strategy-2021.html