For the third time in four years, we find ourselves taking risk down in our multi-asset portfolios in the early weeks of the year, in response to mounting evidence of overheating consensus sentiment and positioning. Indicators showing low cash and high equity weightings among long-only institutions and record net equity exposures among long-short managers paint a general picture of investor exuberance and extended positioning in risk assets. In broad terms, we see the sorts of signals here that typically emerge as equity rallies become exhausted and give way to market consolidations or reversals.
While we share the rosy consensus view of a strong vaccine-driven recovery in global growth and corporate earnings this year, we feel that a fair bit of this scenario is now priced in to financial markets and we would be wary of expecting the rally in stocks to continue in a straight line. The last big v-shaped recovery in global equities, comparable to the current move, was when markets rebounded from the GFC trough in 2009. That rally peaked after a rebound similar in size and age to the one that we have just experienced and then mutated into a lengthy consolidation phase, which didn’t break new highs until 8 months later.
Of course, this week’s chaos in GameStop and related areas has blown some of the froth off equity markets and has certainly transformed the mood of some market participants. The parabolic rise of this stock, reportedly driven by retail speculation, short-covering and options hedging, has reverberated across a number of other stocks and sectors. The pain has mostly been felt by equity long-short hedge funds, which have seen some copy-cat short-squeezes in stocks with high short interest, leading to a frantic de-risking of positions and reduction in gross equity exposures this week.
While the brawl between retail speculators and hedge funds over GameStop has been distracting and at times bewildering, we see it more as being a localised tussle over a highly-contested stock, than something with broader or enduring market significance. Equity markets have, of course, seen a few days of significant volatility, as these battles played out, but the overall impact on long-only investors, quant funds and macro investors has been modest. Spillovers to credit markets, commodities and FX have been fairly inconsequential, so far. Regulators will undoubtedly examine recent developments here and might well take some remedial actions but we see this as largely being a US story, rather than a global one.
While we certainly did not anticipate the sort of speculative surges seen in some US small-cap stocks this week, we did feel that that the strongly trending bull market was looking increasingly likely to soon transition into a more turbulent and directionless trading regime. That’s what we would expect, when investor sentiment is as exuberant as it is today and when investor positioning is as bullish and consensual as it currently stands. While this week’s turmoil has certainly purged some of the excessive optimism and position-crowding from equity markets, this process might well have further to run.
We would however emphasise here that our concerns about sentiment and positioning are tactical and we remain constructive on the fundamental outlook for the global economy and global equities in 2021. While, this week’s skirmishes generated plenty of noise, the trend in the stock market will ultimately be determined by the outcome of the race between coronavirus vaccines and virus mutations. On this we remain optimistic.
