As I peruse various market indicators, current levels of investment, sentiment and positioning, it is clear that sentiment is bullish but not at extremes. Most hedge funds and institutions who came in bearish at the start of 2019 -- for good reason -- got blindsided by a Fed that literally u-turned its monetary policy in one month as the market dropped 15%, despite data suggesting otherwise.
Some funds, like Bridgewater, suffered declines in the first half of 2019, as they continued to keep their bearish bets -- to their detriment as each time the market dipped 5%, it rallied right back up to its old highs. As stocks rise higher in 2019, we have seen a pick-up in equity fund outflows (now at record levels). The breadth of the market is also not what one would suspect at these levels. The strength lies in the S&P 500 only -- but not in the transports or small-cap indices. So, I ask, who is buying this market and why?
Deutsche Bank Analytics released a chart recently showing equity discretionary positioning vs. market performance. There seems to be a divergence now as positioning has been underperforming market performance; an anomaly. Looking at hedge fund performance, they are up around 5% year to date with the S&P 500 up 15% or more -- still underperforming but long, given correlation to the market.
Another chart released by Deutsche Bank Analytics looking at systematic strategy allocations (aka "quants" or "robots"), shows a very tight correlation and one-for-one move higher with the S&P 500, suggesting computer algorithms have been chasing this market higher. We all know these algorithms track just one thing, trend.
They are not cerebral and don't spend their morning coffee time going over investment risk/reward debates about upside vs. downside given upcoming catalysts. They see a trend, press hard on it, and keep running it till their models flash otherwise. The problem is that over time these strategies have so much liquidity and capital chasing them that it dwarfs "traditional" fundamental flow, distorting true price performance. The world of algorithm trading has changed our way of fundamental investing -- only in that it takes longer for real fundamentals to work. You need to be liquid and patient for it to work as the quant flow subsides. And when the trend breaks, it really collapses.
The Nasdaq 100 Index ($NDX) is also making new highs, although it is still below the uptrend line from 2016, and the momentum and breadth shows a topping out pattern suggesting only a few are doing the heavy lifting right now. Investors (in this case humans) are positioned for a slowing down of growth, given broader economic indicators and yield curve and bond market dynamics.
Global stock market momentum has continued to soften going into the July Fed FOMC meeting, as a 25-bps cut in interest rate is already in the bag, and may turn out to be a sell-the-fact event as market expects and wants more ,secretly. Global macro hedge funds are erring on the side of long equities and short volatility, after giving up being short earlier this year. According to the latest date from CFTC on 16 July, the net short position in volatility is about 140,000 contracts. Given hedge funds' outstanding net position in volatility, any increase in market volatility or uncertainty will not bode well for their positioning.
The FX and bond markets are trading logically. Central banks around the globe are now cutting rates, given the economic slowdown with the Fed joining their party recently. However, the dollar is still coming off of a much higher base, as the economic data is slowing but still robust in the U.S. The market expects the Fed to cut by 25 bps and are hoping for 50 bps; either outcome is more than fully priced in by the market. The uncertainty from trade wars escalating, given background commentary and/or the Fed disappointing followed by meager earnings reports in Q2 2019 -- any of this could the break the trend here, it will not take much.
Equities seem to be living in their own little merry world, but are always the last ones to react. Copper, a good proxy for Chinese economic growth, has been trading lower and broken below $6000/tonne Tuesday morning. Mining equities are up 15% or more, despite lower commodity price performance, as they are gung-ho on the Fed saving the day.
Hope is one thing, real earnings and revenue progression is another. The U.S. 10-year bond yields are trading back above 2% and the entire curve (as measured by the iShares 20+ Year Treasury Bond ETF $ (TLT) ) is at risk of moving lower, with yields moving higher and the dollar rallying. If that were to happen, mining equities (as measured by the iShares STOXX Europe 600 Basic Resources UCITS ETF ($SXPP)) will take a hit as copper and other base metals get knocked down on a stronger dollar and slower growth.
Chasing momentum is only as good as the fundamentals allow it. They can diverge from time to time, but eventually they do converge; it is a matter of when, not if.