Another great bit of market commentary from 3D/L.
August saw equity markets rise broadly but quietly, with the S&P 500 gaining 3.04%, bringing it to up 21.58% for the first two thirds of 2021. Overseas markets, especially China, were less serene, with MSCI EAFE up 1.77% and the MSCI China index finishing almost perfectly flat at up 0.01%.
Labor Day is now receding. Summer is over. Time to get back to work. What did we miss? Not much, really.
The Fed has been, and continues to be, a focus for many investors. Anxiety surrounds the expected start of the tapering of Fed policy, where “tapering” is the current euphemism for scaling back the frantic printing of dollars. The timing is less than a complete mystery. Tapering is expected to begin either late this year or early 2022 and last two or three quarters. And the fact that tapering must someday occur has been widely understood since the Fed began printing money as fast as the presses would run a year and a half ago.
What happens after tapering is much less clear. In principle, a reduction in the growth of the money supply would slow the economy and a reduction in the amount of bonds the Fed buys would increase interest rates. Both sound like very bad things for the stock market. But surely an event so high profile and inevitable has already been priced in? Perhaps.
The acronym of the summer was TINA, for “there is no alternative.” Older anglophiles associate the phrase with Margaret Thatcher, who used it in reference to market capitalism. Lately it has been used to justify investing in equities, even as they hit new all-time highs. Fixed income is obviously questionable with tapering on the way, and even cash is threatened by near-term inflation. Assets such as commodities and crypto are too exotic for significant allocations from most investors. That leaves equity. To paraphrase a more famous quip from a much more famous British prime minister, stocks are the worst possible investment, except for all the others you can think of.
The idea that the equity markets are the beneficiaries of a process of elimination, rather than being boosted by sincere enthusiasm, is hardly new. Cynics like us have been offering it as an explanation for new market highs for years. What is new is the mainstream acknowledgement of TINA as a driver, coupled with a feeling that this state of affairs cannot last. It was not that long ago that equity bulls smugly cited FOMO (fear of missing out) as a reason for market gains.
In many ways the capital markets are in a sort of suspended animation, a collective waiting for the other shoe to drop. Yes, the S&P 500 has risen very nicely since the spring, but the significant questions that loomed then are still unresolved. The Fed will taper, just like we all knew it would, at around the time we would have guessed a year ago. It is what comes after that that is still unknown.
And the Great Taper is not the only narrative waiting for an ending. Remember GameStop and the other meme stocks? They are still out there, volatile but still trading at lofty and inexplicable valuations. Their ultimate fate seems fairly obvious, but it is a story in no hurry to unfold.
The market seems similarly unwilling to come to a conclusion on inflation. For several months now, prices have been rising faster than they have in decades, and for several months the market consensus seems to be to wait for more data before taking it too seriously.
Of course, the biggest unresolved plotline is the pandemic. Will it be over soon? Will it ever be over? What would over look like? Will there be permanent changes in the way we live, or will we return to 2019 soon enough? These are challenging questions, and if there is one issue that is holding up resolution on others, it is this one.
In retrospect, the stock market enjoyed a quiet summer. Now back to work. There is much work to do.
The Market Sentiment Framework
We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.
The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant and uncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.
August saw both the Optimism and Efficiency levels decrease modestly.
Optimism began the month at 0.32 and ended the month at 0.20, continuing a trend from July. Although still relatively low in absolute terms, Optimism is well above its pandemic lows and not that far from its post-COVID high of 0.70 seen in mid-April of this year.
Efficiency fell, starting the month at near zero and ending at -0.24. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is still under stress, and indeed increasingly so.
Both measures are higher than where they were in early 2020, but have trended lower since the spring. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with modestly optimistic but still fearful investors. This would imply a positive but challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.
