August 31, 2020
Optimism For Stocks Is On the Rise -
And That Is Concerning
The S&P 500 racked up another big gain in August rising 7.2%. This makes it five straight months of gains since bottoming last March — and investors are starting to take notice. They are noticing, for example, that S&P 500 earnings estimates for the second quarter proved way too pessimistic. With 95% of firms now reporting, earnings are 18% higher than estimated just a month ago. And estimates were raised for five of the next six quarters as well (though by much smaller amounts ranging from 0.5% to 4.1%).
They are noticing that more and more sectors of the economy are showing signs of "v"-shaped recoveries. I noted new home sales and retail sales last month, and this month we can add industrial production, durable goods orders, and existing home sales. Also joining that list is one of my favorites indicators — the three-month moving average of the Chicago Fed National Activity Index, which includes 85 different economic variables.
Investors are also noticing that new cases of Covid-19 have been declining since late July and are now running at half what they were back then (though they still need to fall in half again to match where they were at the end of May). And they have seen progress towards a vaccine continue to show promising results.
In short, there is a lot to like about the current situation. As a result, investors who remained pessimistic after the Covid-crash, have seemed to finally embrace this rally. According to the Chicago Board of Exchange, the demand for put options (the right to sell a security at a pre-set price, which investors purchase when they are bearish) versus call options (the right to buy a security at a pre-set price) is the lowest in more than a decade. At 76 (on a scale of 0-100) the CNN Business Fear and Greed Index is registering extreme greed (a year ago it was just 18, or extreme fear). Other sentiment indicators are signaling similar optimism, and that is often a contrary indicator in the short-run as it means a lot of the "good news" is already baked into stock prices.
This turn in sentiment, along with the outstanding returns our model portfolios have so far enjoyed this year, prompted us to review their risk levels. We entered the year overweighted in large-cap growth funds, dominated by tech. Unless you’ve been living under a rock, you know tech has been the runaway best performing sector this year. As a result, growth funds became an even higher portion of our models, resulting in an increase in risk that’s above our targets in some models — especially more conservative ones. So these trades rebalance our models to better align them with their risk targets. In most cases, that meant a reduction in risk.
Importantly, I remain positive on the longer-term outlook. But I think that aligning risk closer to our targets makes sense. In the process of rebalancing, we have modestly increased our position in unloved value stocks. We may give up some return going forward if tech continues to dominate, but it is worth noting that the difference in valuations between growth and value stocks has, by a couple of measures, risen back to the extreme levels we last saw back in 2000.
— John M. Boyd