(TheStreet) - "There are decades where nothing happens; and there are weeks where decades happen." - Vladimir Ilyich Lenin
Lenin's comments certainly apply to the inconsistent, frenetic and manic market (down and up) action of the last several months.
While I thought that the move lower in the market in June provided a good entry point, based upon our calculus of upside reward vs. downside risk - the speed and magnitude of the strong advance during the month of July surprised me.
Indeed, the swiftness and size of the rise in equities last month have recently driven the markets back to valuation levels that concern me - reducing the general attraction of equities and posing the risk of more negative outcomes for stocks.
I now believe that risk assets are at risk.
It should be clear that in observing the unusual market volatility and frenetic weekly/monthly moves that we are not in our father's market - things have changed as markets have grown increasingly manic.
I will try to explain how and why the market has changed and why a tactical/strategic flexibility and continued opportunistic trading and investing programs are incumbent in the current market setting, in order to deliver attractive, risk-adjusted returns.
As I wrote in my Diary back in May:
"Performing well during this unsteady and uneven period has required a flexible and opportunistic approach, an understanding of the changing market structure, the implementation of risk controls and price discipline coupled with a premium on common sense, experience and a sense of investment history.
Surviving and even prospering in such a challenging market and rapidly changing economic, social and political backdrops have placed demands on investors who have experienced a near uninterrupted thirteen-year Bull Market since March 2009.
The days of buying thirty core investments and sitting back and watching their steady appreciation appears over - as the next several years will require far different skill sets that succeeded in the last decade. Without the ability and willingness to trade and short stocks - something that many money managers are restricted from or are not proficient in - may be akin to investing with one hand behind one's back. While this might sound self-serving, a new regime of volatility, uncertainty and less steady (upwards) trending market conditions are an ideal environment for supple and opportunistic hedge funds."
Last Saturday I had I lunch with my old boss (I was briefly Omega's Director of Research), iconic investor and longtime friend and mentor, Omega Advisors' Lee Cooperman. We have known each other for four decades and I can testify that Lee is a thoughtful and optimistic person and investor. Today he believes while U.S. stocks may be the best asset in the financial asset neighborhood, he doesn't like the neighborhood.
Here are some of the thoughts and pearls of wisdom that Lee communicated to me last week:
Lee is of the view that we face rising rates, which are too low given inflation, worse than expected inflation and higher taxes.
Because of excessively stimulative fiscal and monetary policies stock returns have borrowed from the future.
The absence of political cooperation holds policy risks.
Like me, Lee sees a threat from machine-driven changes in market structure.
Lee observes that while nominal profits are currently doing well, not so much after adjusting for inflation. The bottom line is that Lee sees S&P fair value at about 18x projected EPS of $230/share - which equates to about 4140. However, if we get a recession next year, profits can drop to $180/share, using a 20x price earnings multiple yields 3600 on the S&P Index.
Looking out further in time - and this is important - Lee sees the January S&P level (of about 4800) not only the high for the year but he wouldn't be shocked if it was a high for several years.
Last week, in an interview in the business media, Lee cited the pharaoh's dream as recounted in the bible and interpreted by Joseph. The dream was the seven fat years he experienced would be followed by seven lien years. We have been through one of the most speculative periods in our investment lifetime - aided by zero interest rates and zero commissions. SPACs, would be FANGS with outlandish valuations and zero earnings, etc. It is hard for Lee to imagine that we will be back to a bull market very soon.
Market Structure and Positioning
Market structure changes have been important determinants to the supply and demand for equities over the last several years. Structural changes have had particular impact upon short term (weekly/monthly) investment returns.
A decade ago, active investing, on the part of hedge funds and other institutional investors, dominated the investment scene. Passive investing played a limited impact on markets. Since then, passive strategies and products have gained popularity and now account for the lion's share of aggregate trading activity.
Passive investing - quant strategies like risk parity and exchange traded funds - are machine, and algorithm, driven. They are emotionless and operate at breakneck speed. Passive investing worships at the altar of price momentum - they know everything about price and little about value. This helps to explain why these systematic programs "buy high and sell low."
The influence of passive products and strategies cannot be understated as they have become the tail that wags the investment dog.
It is estimated that 80% of market volume is quantitative and passive trading. The other 20% of market volume is active trading - mostly hedge funds. They are the marginal buyer.
When price momentum shifts to the upside, as it did in early July, the 80% passive (quant strategies, Et al.) follow prices higher and buy.
That other 20% of market volume are hedge funds, asset managers and retail accounts. All three of these constituencies began July defensively positioned. Remember the BOFA bull/bear indicator had fallen to ZERO 45 days ago!
Positioning has also become an important determinant to the direction of stock prices. And, as expressed, in our letter last month, positioning at the beginning of July was defensive and risk averse as many hedge funds degrossed and derisked.
As I have noted, almost every smart hedge hogger I know was bearish at the end of the first half of 2022. In the past I have used Dan Loeb's Third Point hedge fund as a proxy for the hedge fund community. Dan is the best of breed. In his investor letter he said he was over 70% net long at 2021-year end, 40% net long in April I believe, and in June a bit over 20% net long.
In the last two months we have witnessed the dual impact of both passive and defensively positioned active players buying. This has intensified over the last several weeks.
To summarize, while market structure and positioning usually doesn't have a long-term impact on equities, we learned over the last two months that it certainly can impact the short-term performance of stocks.
Renewed Concerns
July's market strength was the polar opposite of June's weakness. Markets experienced their strongest gains since November 2020.
While I was growing more optimistic, on a trading basis two months ago, we did not expect the rally to be as swift and as violent to the upside.
To justify buying at today's prices means that one expects a new Bull Market leg - something I remain dubious of.
To me, besides low valuations, the proximate cause of the July advance was the market's interpretation that the Federal Reserve is on the path of a "soft pivot." We are of the view that market participants have misinterpreted Fed Chairman Powell's intentions:
* While I have been in the "Peak Inflation" camp, I think inflationary pressures will be more stubborn than the consensus expects - in my base case of a "mild and brief" economic assumption. Structural headwinds to lower inflation remain - wages, rents and the price of durable goods.
Recently, Peter Boockvar put a bit of math behind the argument that inflation isn't going back to a sustainable 2% pace or less for a while.
* The recent easing of financial conditions has run counter to the Fed's likely path and, as seen over the last week, several Federal Reserve members have pushed back on the notion of a soft pivot.
* I expect a continued hawkish Federal Reserve and, with equities elevated, there is renewed market vulnerability. A major difference between today and prior bear markets continues to be Fed policy. During the previous eight bear markets the Fed responded with easy money every time, with rate cuts and quantitative easing, etc. This year the Fed is doing the opposite - hiking rates and starting to shrink their balance sheet. The last time we saw a hawkish Fed was during the bear market of the early 1980s when Paul Volcker led the Federal Reserve:
Unlike previous cycles, if the economy disappoints greater than expected, the Fed does not have the monetary tools to revive it. Nor do authorities have the fiscal tools and flexibility.
* Non-U.S. economic prospects - especially in China and EU - have not improved. In fact, since we turned a bit more constructive on the markets six to eight weeks ago, the non-U.S. economic outlook has measurably deteriorated. Based upon our research, China, in particular, likely faces the threat of lower than expected Industrial Production, retail sales and fixed asset investment. Unless China abandons its aggressive Zero Covid policy, expected interest rate and reserve requirement cuts are unlikely to reverse the region's southerly economic destination.
I am skeptical that the U.S. can be an oasis of prosperity in an interconnected and flat economic world.
* As noted by Lee Cooperman, above, I remain concerned about the buildup of private and public debt loads which act as a governor to growth:
* The earnings season, though better than many feared, has still not been good as forward guidance has disappointed and has raised more questions about prospective trends in profitability:
Q2 2022 S&P profits excluding the contribution of the robust gains in the energy space, declined by 3.7%.
Consensus corporate profit expectations are too elevated. Indeed, the pace of the rise in input costs will likely lead to an earnings recession over the next few quarters. The PPI (Producer Price Index) has now eclipsed the CPI (Consumer Price Index) for 29 straight months. As an example, last week's PPI rose by +9.8% compared to "only" +8.5% in the CPI. Input costs are outpacing the ability for corporations to pass on higher costs to the consumer:
Investor expectations and sentiment, so dour six weeks ago, is now elevated. An oversold market in June has become overbought on every measure we look at as market strength is being bought. Short positions are being aggressively covered and fear of the return of capital has quickly morphed into the fear of missing out ("FOMO"):
* Valuations have reset higher, quickly reversing the previous lower valuation opportunities. In June only 2% of the S&P Index components traded above their daily 50 day moving averages. We are now back to 86% of the S&P Index above their moving averages!
Daring to Be Different
* I see myself as a contrarian with a calculator in hand.
I invest by doing what we view as correct and not necessarily by doing what is popular or consensus.
Most investors find it hard to venture out in the herd.
My market view is never based on price momentum - it is always based on our assessment and in the calculus of upside reward vs. downside risk.
Back in June I wrote in my Diary that "when the time comes to buy, most investors won't want to."
Today I write "when the time comes to sell, most investors won't want to."
Another friend (and someone, like Lee Cooperman who has importantly influenced me as a money manager) Oaktree Management's Howard Marks, recently wrote about how non consensus money management can lead to superior investment returns, in his commentary, "I Beg To Differ":
"Of course, it's not easy and clear-cut, but I think it's the general situation. If your behavior and that of your managers is conventional, you're likely to get conventional results -- either good or bad. Only if the behavior is unconventional is your performance likely to be unconventional ... and only if the judgments are superior is your performance likely to be above average.... The consensus opinion of market participants is baked into market prices. Thus, if investors lack insight that is superior to the average of the people who make up the consensus, they should expect average risk-adjusted performance."
I bought the June weakness (when fear was pervasive and there appeared to be no bottom for the market) and reduced our exposure into the heady move in July (when greed unexpectedly appeared and there seemed to be no top for the market).
Here is an expanded discussion of non-consensus investing from Howard Marks.
Bottom Line: Price Is What You Pay, Value Is What You Get
* Market structure and positioning have had a lot to do with the recent market advance
* I now believe risk assets are at risk
* In late July I faded the emotional burst of buying and reduced our long exposure
* Consensus profit estimates remain inflated and inflation will likely be sticky
As discussed in our recent Bloomberg interview - at the 20 minutes, 50 seconds mark - the markets have benefited dramatically from defensively positioned institutional and retail communities' bearish positioning since early June.
As stocks have rallied, market structure has kicked in and passive products and strategies which worship at the altar of price have bought into the rally - arguably exaggerating the upside move. Meanwhile, defensively positioned investors who had derisked and degrossed, who are now fearful of missing out (FOMO) have been forced into the markets.
This has occurred even though the Fed has pushed back from the notion of a soft pivot and as Peak Inflation, which we had expected, was proven out by the CPI and PPI prints.
Recognizing that long positions have historically generated wealth (and short positions protect wealth!) I would prefer to buy and hold. But, as mentioned in this monthly commentary, based on the artificial, exaggerated and non-fundamental impact of market structure and positioning, market conditions have swiftly moved to becoming less attractive.
In my view, the available opportunity set of six weeks ago has likely come and gone and a heightened regime of volatility and market vulnerability may, again, lie ahead.
On a more fundamental basis we continue to remain concerned - as we did at the beginning of 2022 - about the likely path of (hawkish) Fed policy, rising valuations, weakening global economic growth and the growing vulnerability of U.S. corporate profits (and margins).
On the later score I would note only 57% of the companies that have reported 2Q2022 results have beaten EPS and sales estimates (it was over 70% in the previous quarter). Moreover, one out of every five companies have lowered guidance.
To conclude, today's column is a reality check.
I have dramatically reduced my long exposure and have reestablished a much more conservative portfolio construction.
For the first time in a while, I am finding appealing short opportunities to complement my long holdings.
(This commentary originally appeared on Real Money Pro on August 16. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)
By Doug Kass
August 16, 2022
