(3DL) April was a hard month for stocks, with the S&P 500 giving up -8.72% on a total return basis and the MSCI EAFE ceding -6.5%. And, of course, April was a bad month that followed a bad quarter, bringing the S&P’s four-month year-to-date return to -12.92%. Those four months have essentially wiped out the gains of the eight months previous. The rolling one-year return for the S&P, April 30, 2021 to April 30, 2022, is just 0.21%.
Negative themes that drove April’s losses were essentially identical to those of the first quarter. Chief among them was inflation and the Fed, but a dismal war in Ukraine and a nostalgia-inspiring worry about COVID in China played a part as well.
It would be hard to discuss inflation and the Fed without sounding like a broken record, an expression that must be lost on many under the age of 45 or so. And it is the many market participants too young to remember how vinyl records could sometimes scratch causing an endless loop that worry us. For these are also the investors who cannot remember the bad old days, when fighting inflation was thought to be the Fed’s primary role, one it performed with mixed results.
Today, in the brave new world of quantitative easing, negative interest rates, student loan forgiveness, and modest million-dollar suburban houses, the lessons of the late 20th Century seem lost. The chain of events that we oldsters would expect to see after a massive increase in the money supply, inflation followed by significant increases in interest rates, appears to be a surprise to many 21st Century investors.
April saw at least one indication that 21st Century faith and optimism was giving way to 20th Century cynicism. The first quarter of the year saw the five largest members of the S&P 500 (Google, Amazon, Apple, Microsoft, and Tesla) continue their charmed existence, as they outperformed the S&P, losing -3.29% as a group, ahead of the -4.10% for the S&P. But in April the magic seemed to fade, as the top 5 collectively lost -14.75% for the month and -17.55% year-to-date, against -8.72% and -12.92% for the index.
Earnest believers in rationality might point to disappointing quarterly reports from some of the top 5, but after years of gravity defying and fundamentals ignoring gains, it seems disingenuous to blame April on something so prosaic as poor earnings or sales.
No, the dawning fear in the minds of investors is that this may be an authentic, old fashioned, bear market. The top 5 led the way up over the past few years, so it is not unreasonable to imagine that they might lead the way down now. We are not ready to say this is a bear market, but it must be conceded that the market psychology seems to be pointing that way.
As generals always fight the last war, so investors tend to prepare for the previous bear market. In this case that means that they either do nothing, as the dips of 2018 and 2020 turned out to be short lived and harmless, or they do what would have been effective in 2007-09. Neither of these approaches strikes us as sound.
A currently popular method of hedging equity market exposure is to go long equity volatility indexes, specifically the CBOE Market Volatility Index, known to its friends as the VIX. This is an indirect hedge based on the principle that when stock prices decline their volatility tends to substantially increase. As general tendencies go, this is a strong one, and it certainly would have been a successful strategy in 2007-09.
But it is still an indirect hedge, one that is susceptible to the obvious possibility of a long and quiet, that is, low volatility, decline in the market. The VIX ended April at 33.40, well up from the 17.22 level from end December ‘21 (it ended November ’21 at 27.19) but nothing like the highs of 85.47 from March 18th, 2020 or 89.53 from October 24, 2008. In a market that is characterized by slowly growing dread and the crystallization of fears, rather than a sudden crisis and panic, a volatility hedge could be disappointing.
With all that said, we are not yet convinced that this is a bear market. As of the start of May, our domestic equity models still have us fully invested. Further, we suspect that a bear market in equity, should it arrive, will probably be a buying opportunity in hindsight. The troubles now weighing on the capital markets are fundamentally monetary and fixed income related. Stocks, expensive as they may be, are innocent bystanders.
Indeed, in as much as the ownership of equity is the ownership of a collection of real assets, stocks are one of the better places to ride out an inflation wave. Moreover, in retrospect the bad old days of the late 20th Century were a great time to buy, something those of us who remember music on vinyl ought to tell the kids.
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.
Optimism declined slightly in April, while Efficiency fell, but still stayed within the range it has inhabited for six months.
Optimism began the month at -0.54 and ended at -0.60. Although it has decreased steadily since mid-2021, Optimism is still well above its pandemic lows seen in the first half of 2020.
Efficiency fell, starting the month at -0.09 and ending at -0.39. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is increasingly under stress.
Both measures are higher than where they were in early 2020 but have trended lower over the past year. 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.
