3D/L: Rotating Backward But Not Losing Ground

3D/L's monthly market commentary is always full of charts and statistics, but this narrative section is the best encapsulation of the firm's differentiated point of view. This is from the Lee Adaptive Strategies team.

Broadly speaking, it was a good month and a good quarter. The S&P 500 and MSCI AC World were up respectively 4.38% and 2.72% total return for the month of March. For the first quarter of 2021 they gained 6.18% and 4.68%. Often when we recite solid but not spectacular returns such as these we provide a caveat that the quiet total result hides more exciting details. Not in this case.

There was much discussion of a rotation within the market, from formerly favored names and sectors to formerly unfavored ones. And this was more than an idle rumor. It did happen, but it was not particularly extreme, nor is this sort of reversion to the mean, where underperformers and outperformers switch places, anything out of the ordinary.

The table above shows the first quarter 2021 and full 2020 total returns for the eleven State Street sector ETFs, as well as the iShares small cap (Russell 2000) ETF. Energy was by far the best performer in the first quarter, just as it was by far the worst performer in 2020. Indeed, it is hard not to mention that even though it was up more than 30% over the past three months, it is still down -11.71% since the end of 2019, a period during which the S&P 500 gained 25.71%.

Technology is, as advertised, near the bottom of the table, at up a mere 2.36% for the quarter. Then again, it did go up. Considering the is-that-a-typo appreciation it enjoyed in 2020, that it added further to its gains is somewhat remarkable, even if it did lose a bit of ground relative to the broader market.

But to many observers, that technology was a laggard in a period of increasing economic optimism is confusing, if not alarming. Generally speaking, as you come out of a recession, or anticipate coming out of a recession in the near future, economically sensitive sectors such as technology, consumer discretionary, and communication services would be expected to do best, just as those same sectors would have been expected to suffer during the recession. This cycle seems backward.

Economic crises often inspire a flight to safety in the stock market, meaning that investors typically shift their equity holdings in favor of reliable and less economically exposed names. Historically this has led investors to such places as health care, staples, and utilities, none of which particularly prospered in 2020. (And, somewhat unfairly, all did poorly this past quarter.)

The safe destination for investors in 2020 was not places like Proctor and Gamble (which lagged the S&P for 2020 at up 13.90%) or Pfizer (up 3.27%), but Amazon (up 76.26%) and Tesla (up 743.44%). We think that is not quite as crazy as it might appear to be at first. The idiosyncrasy of this recession was that it was widely understood to be temporary. With hindsight, all recessions are temporary, but in the past that fact has not been so obvious while they were occurring.

If you expect a lousy economy for the next 12-24 months, but then a return to exuberant prosperity, where would you put your money? A company that makes laundry detergent, or better yet toilet paper, might be a good choice. But how about a company that is on such a strong and long-term growth trajectory that the next two years of results are immaterial to its valuation? The Tesla story is not about 2020, it is about 2030 and 2040, by which time we will each own at least four of their cars.

Of course, the more significant rotation over the past year has not been within the equity markets but into and out of them. Running scared to safer stocks is not nearly as reassuring as running out of the stock market altogether. And as notable as Tesla is, the big picture story of 2020 is a period of panic in February and March followed by a long and sustained market rise as that panic receded. Interestingly, the rally continues today, long after the S&P surpassed its pre-panic levels.

The obvious destination for money leaving equity was fixed income, and combined with unprecedented purchases by central banks, at the height of the crisis bond prices soared. Some of the more recent appreciation in the stock market has likely been due to an unwinding of this flight to fixed income, but the Fed continues to heroically support bond prices and interest rates are still near historic lows. We will not reshare our inflation anxieties this month, but suffice it to say that Treasures paying negative real rates are likely to see downward pricing pressure.

Does a worsening of the outlook for bonds imply an improving outlook for stocks, as investors shift from one to the other? That may be the recent experience, but it is worth remembering that returns are not always driven by rotation, that the returns from the equity and fixed income markets are positively correlated, and that when one goes up or down the other usually does too.

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 anduncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.

Both measures modestly rose in March.

Optimism began the month at 0.55 and increased to 0.67. Although a small increment and still at a low level in absolute terms, the multi-month positive trend continues to suggest a warming in investor outlook.

Efficiency also gained, beginning March at 0.30 and ending at 0.71. Efficiency continues to be comparatively low in absolute terms, which suggests a market that is still under stress.

Both measures are higher than where they were pre-COVID. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with marginally optimistic but 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.