What a week!!! After posting a tweet that went viral regarding 3x levered Tesla ETF (Exchange Traded Fund), the stock market, more so the Tech sector, began its much overdue market pullback. Now, I am not saying my tweet was the catalyst, or maybe it was 😊, but it signified how frothy the market has/had become. Needless to say, asset mania in the high-flyer growth names was alive and present.
Over coffee this morning we will put in context how market pullbacks are healthy occurrences when markets become frothy, rather than serve as a prelude to something more sinister brewing underneath the surface. So, grab your cup of coffee, or café au lait with a bit extra froth, and enjoy!
As you know, we’ve been highly constructive of a renewed business cycle which will lead to improving economic conditions. While most market participants focus on lagging economic (LEIs) data, we’ve been hyper focused on the V-shaped recoveries that have unfolded in many high-frequency leading economic data points. The improvement in PMIs (one of our favorite LEIs), housing, industrial commodities, freight movements, TSA check-ins, jet fuel demand, and slowing jobless claims all point to a sustainable economic recovery. But even while economic conditions are improving, we began to highlight complacency risks embedding within the financial markets. One of the data points we use to measure complacency within the financial markets is the Put/Call Ratio. This data point measures how many put option contracts (an instrument you purchase if you believe asset prices are to go down) versus call option contracts (an instrument you purchase if you believe asset prices are to go up) over time. You will see in the chart below that amount of call option purchases (betting prices will go up) versus put options (betting prices will go down) hit a statistical extreme low. This, amongst a variety of other indicators we follow, signaled complacency.
While market pullbacks are never a fun experience, we must discern between a market pullback that signifies a potential risk event building underneath the surface, or a healthy pullback from an overbought market. We do this by monitoring the relative performance of economic sensitive areas of the market versus the beloved “defensive/stay-at-home” areas of the market. What we saw is that the most economic sensitive segments of the market not only outperformed relatively, but absolutely. To stress this point further, if we look at the market correction that lasted from Feb. 20th to Mar. 23rd, it was led by the economic sensitive segments of the market, thus representing an actual economic situation; COVID-19.
While technology stocks have been the beloved darling of Wall Street and Main Street investors alike, we urge caution that complacency within these “defensive” segments may lead to subpar outcomes. Based on our assessment of improving economic conditions, we’ve been arguing that economic beneficiaries should begin to take the baton as the economy recovers. This has been evident in the outperformance of cyclical sectors and factors over this latest pullback.
We have begun tilting into economic beneficiaries and look at durable pullbacks as healthy cleanses which allow us to increase our risk-asset exposure. Nonetheless, we still proceed with caution as complacency still is evident within the financial markets, seasonality (risk-assets struggle this time of year), and the polarizing political landscape of the upcoming election.
I hope you have a wonderful holiday weekend and I look forward to continuing our chat next week!
Andrew H. Smith
Chief Investment Strategist