The juxtaposition of the dual records is so glaring that it cannot avoid mention: The major U.S. stock market averages have attained record highs at the same time that Covid-19 cases and deaths in America have hit new peaks.
Financial markets, of course, focus on the future rather than the present, and they see vastly better days ahead in 2021, especially now that the pandemicâ€™s end is in sight. One vaccine began to be administered this past week and, as I write, a second appears headed for approval shortly, bringing more hope for an end to the pandemic by 2021â€™s second half. But they canâ€™t immediately stop the rising toll that threatens to outstrip the capacity of many hospitals in the U.S. to treat coronavirus patients.
After this annus horribilis, itâ€™s almost impossible not to expect a better year ahead. Strategists forecast equity returns in the high single digits for 2021. In most years, however, the median call is for such returns, given that few seers will stray very far from the consensus. As John Maynard Keynes observed, â€œWorldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.â€
Predictions of further advances from the fresh peaks set this past week in the major indexesâ€”the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite, plus the previously lagging Russell 2000 index of smaller-capitalization stocksâ€”speaks of clear optimism for 2021. Especially given how far these indexes have come from their lows of last March, from a gain of 63% for the Dow to 86% for the tech-heavy Nasdaq to over 99% for the Russell 2000.
Yet in a pithy Morning Porridge daily note, Bill Blain, a banker at Shard Capital in London, offers this take on the obligatory forecasts: â€œBasically, the message is: To make returns next year, just join the never-ending stock-market upside. While rates will remain low in the long term, money flowing into stocks will ensure that they trade up on ever higher multiples. To generate returns, I have to take increasing riskâ€”that feels like a massive trap!â€
Nevertheless, the professional fund managers responding to Bank of Americaâ€™s latest survey appear to be all in, or nearly so. Cash holdings were down to 4%, the lowest level of 2020 and the first time the respondents were underweight cash since May 2013. Hopes for the Covid vaccines led them into â€œreopening tradesâ€ in consumer and commodity names, along with emerging markets.
As for â€œcrowded trades,â€ investing in technology stocks remained the biggest in the BofA poll, followed by shorting the dollar and buying Bitcoin. None of those qualify as fresh ideas. Along with the Nasdaq, Bitcoin also set a high in the past week, while the U.S. Dollar Index fell to its lowest level since April 2018.
While the pros have been moving out on the risk spectrum to produce returns (and preserve their employment), the amateurs have gone full tilt into trading for fun and, in this bull market, presumably profit. Individual investorsâ€™ trading of single stocks and options has gone parabolic, Jim Bianco of Bianco Research points out. They are purchasing shares directly, as opposed to taking diversified positions in exchange-traded funds, and making leveraged bets in options.
Indeed, since the marketâ€™s liftoff in the spring, small options tradersâ€™ market activity has dwarfed that of large ones, he says. In a chart, Bianco shows that options activity has tilted heavily to bullish call options over bearish puts since then. This structural shift in individualsâ€™ feverish trading indicates that â€œthere is more than excessive optimism in the market,â€ he concludes.
This may be a manifestation of the Dunning-Kruger effect, writes Doug Kass, who heads Seabreeze Partners Management while prolifically publishing missives on the markets and more. Dunning-Kruger is a cognitive bias that deludes people into thinking they know more and are more capable than they really are. Sufferers donâ€™t know how much they donâ€™t know, and the most ignorant are the most confident.
â€œWith the benefit of a zero-commission trading app, it is now easy and costless to trade, and the Covid-induced â€˜stay at homeâ€™ factor, coupled with the desire of many to reclaim agency, have contributed mightily to 2020â€™s trading fever,â€ Kass writes.
Free trading might have been expensive for customers of Robinhood Financial, which the federal Securities and Exchange Commission this past week accused of misleading users about how the popular free-trading platform makes its money.
But those actions pale against the regulatory risk faced by the technology giants. Two antitrust suits were filed this past week against Google parent Alphabet (ticker: GOOGL), atop another filed in October. The new legal moves came a week after a suit was filed against Facebook (FB) over its acquisitions several years ago of Whats App and Instagram.
Meanwhile, the European Union is looking at Amazon.com (AMZN) over its marketplace practices, while Alibaba Group Holding (BABA) and Tencent Holdings (TCEHY) have drawn scrutiny from Chinaâ€™s regulators.
But even though tech is in the crosshairs of governments around the globe, its share prices have scarcely flinched, except for those of the Chinese companies.
So long as the markets continue to be boosted by extremely accommodative monetary policies and expectations of further fiscal measures, regulatory risks may remain in the background.
The Federal Reserve this past week underscored that it will continue its near-zero-rate policies and its securities purchases of at least $120 billion a month until it is satisfied that full employment is reached and that inflation has topped its 2% target, making up for past undershoots of that mark.
Depressed fixed-income yields around the globe, with more than $18 trillion in bonds trading at negative yields, undergird all asset prices, including those of stocks.
Fed Chairman Jerome Powell, when asked about equity valuations at his news conference Wednesday, allowed that price/earnings multiples were on the high side, but added that the equity risk premium wasnâ€™t out of line, given low Treasury yields. But, notes Cliff Noreen, head of global investment strategy at MassMutual, this suggests that the optimistic outlook for next year is discounted in current stock prices.
At the same time, the Fedâ€™s rate repression hasnâ€™t eliminated credit risk, but has invited borrowing at historically low rates, observes Harley Bassman, the former head of mortgage operations at Merrill Lynch. So, he suggests on his Convexity Maven blog, investors should take advantage of these trends in the new year.
One way would be an options trade best suited for investors who already own stocks and might want to take profits now, perhaps to pay the current low capital-gains tax rate, which the coming Biden administration probably will try to increase (assuming approval by the Senate, control of which hinges on the results of the Jan. 5 Georgia runoff elections). When all the monetary and fiscal stimulus combines with a vaccine producing herd immunity, Bassman sees consumer spending exploding. Inflation eventually is coming, bolstered by millennials entering their prime spending years, in a replay of what happened with baby boomers in the 1970s.
He suggests buying a long-term call on the SPDR S&P 500 exchange-traded fund (SPY) with a strike price of 410 and expiring Jan. 20, 2023, at $19, when SPY trades at 365. He would pair that with the sale of a SPY 275 put with the same expiration and at the same price. The trade would give up the first 12.3% of an advance (which is how far the call is out of the money) in exchange for avoiding the first 24.7% decline. Users of this strategy should be prepared to buy SPY at 275, which would mark a 50% retracement of the past five-year bull run, he adds.
Another, less esoteric move might be to buy mortgage real estate investment trusts, which Bassman previously recommended here. His rationale remains the same: The Fed is holding down the borrowing costs for these leveraged entities, while also suppressing the volatility of the assets on the other side of their balance sheets. While he doesnâ€™t name specific REITs, he notes that the group yields substantially more than junk bonds. For example, the VanEck Vectors Mortgage REIT Income ETF (MORT) yields 10.24%, versus 4.89% for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).
Bassman also favors municipal-bond closed-end funds, which he discussed back in June. These were the subject of a recent screen on Barrons.com, focused on those with a tax-free yield around 4.50% or higher, which exceeds what junk-bond funds generate for someone in the 24% bracket, and more for those who pay higher taxes.
Finally, he suggests gold as a very long-term hedge. Even though a 5% allocation likely could be dead money for some time, it will let him sleep at night.
In the short run, however, bulls are looking past whatâ€™s happening now to what they expect will be the much better days of 2021, when the pandemic is put behind us.
Deutsche Bankâ€™s recent survey of investors found what its head strategist Jim Reid called possibly â€œthe biggest consensus in history,â€ favoring U.S. equities, followed closely by emerging market stocks. The three biggest risks respondents see are the virus mutating into a strain that vaccines canâ€™t stop (some 38% fear this); serious side effects emerging, as already seen in a few individuals prone to severe allergic reactions (36%); and a substantial number of people refusing to take a vaccine (34%).
That doesnâ€™t imply widespread worries that the Covid-19 vaccines will fail. But it suggests that the markets already have largely discounted their success and the much-anticipated second half recovery. So investments that depart from the bullish consensus and offer yield might be worth considering.
Write to Randall W. Forsyth at email@example.com