Mid-week market update: About two weeks ago, I identified an emerging theme of a rotation out of large cap growth stocks into cyclicals (see Sector and factor review: Not your father’s cycle). The latest BoA Global Fund Manager Survey (FMS) confirms my analysis. The rotation is attributable to managers buying into the reflation trade.
Does that mean you should hop on the reflation train? Is there sufficient momentum behind this shift?
Growth expectations revival
Actually, the shift into the reflation trade is mis-named. It’s not that inflationary expectations that are rising that much, but growth expectations.
The growth to cyclical rotation can be seen in regional weightings. For several months, managers had been piling into US equities as the last source of growth in a growth starved world. The FMS had shown the US as the top weight in equity portfolios for some time. In the latest survey, the top regional overweight is now the eurozone, as managers have latched onto the reflation and cyclical theme.
A cyclical report card
How are cyclical stocks are performing. First, it’s unclear how well the rotation into eurozone equities will work out. High frequency data shows that the recovery is stalling on the Continent.
In the US, the relative performance of cyclical stocks presents a mixed picture. While homebuilding stocks are on fire, the relative performance of other cyclical sectors and industries show constructive but limited signs of market leadership. Material stocks are turning up relative to the market, but industrial, transportation, and leisure and entertainment are only exhibiting bottoming patterns.
I have made this point before, this is not a normal economic cycle and interpreting it that way can bring trouble for investors. Instead of a normal Fed induced slowdown, the global economy encountered a pandemic driven sudden stop. The pandemic is still ranging all over the world, and the recovery in demand will depend mainly on how well the human race can control the COVID-19 outbreak. Therefore the recovery will not follow the normal patterns of past economic cycles (see Sector and factor review: Not your father’s cycle).
I believe that equity risk and return are asymmetrically tilted to the downside. Conventional sector and factor analysis is pointing towards a rotation out of US large cap growth stocks into cyclical and EM equities. However, this is not a normal cycle and many of the usual investment rules go out the window. Historical analogies are of limited use. This is not 2008 (Great Financial Crisis), 1999 (Dot-com Bubble), 1929 (Great Depression), or 1918 (Spanish Flu).
Investors have to consider the bearish scenario that a rotation out of US large cap growth does occur because of a crowded long positioning, but the rotation into cyclical and EM does not occur. Instead, the funds find their way into Treasuries and other risk-off proxies because of either the failure of early vaccine trials, or teething problems with deploying vaccines and therapeutics. In that case, the growth path falls considerably from the current consensus, and a risk-off episode and valuation adjustment follows.
Focus on risk, not return
Under these conditions, investors are advised to focus first on risk, than return. Mark Hulbert observed that his Hulbert Stock Newsletter Sentiment Index is higher than 95% of all daily readings since 2000. That’s a crowded long condition, which is contrarian bearish. While the market can continue to advance under such conditions in the past, intermediate term risk and reward are not favorable for equity investors.
In the short run, the NASDAQ leadership remains intact. While the 5-day RSI continues to flash negative divergences for the NASDAQ 100, the index has shrugged off these warnings and continued to rise. Until we see signs of trend breaks, either on an absolute or market relative basis, it would be premature to be bearish.
The market can continue to grind higher in the short-term, but investors who focus on risk and reward are advised to be cautious. There’s probably turbulence ahead.