Q1 2021 Commentary

We began the first quarter of 2021 with our core strategy (domestic Time Overlay) taking its most conservative positioning since 2007. 

We finished the quarter with that strategy moving to its most conservative positioning since 1998.

For the first time in over 22 years, clients following our core strategy are 100% invested in cash and money market funds.   This approach has targeted 100% cash two other times since (1999 and 2006), but client accounts never quite caught up with targets before they resumed buying.

This sounds like a dramatic call, and in terms of its absolutism, it is.  But pragmatically, it is merely an incremental adjustment from the already-low baseline investment levels we have repeatedly returned to in recent years.

Our move to 100% cash is not based on any significant shift in data or the anticipation of an imminent market collapse. The move is reflective of a gradual and prolonged accumulation of data projecting weaker anticipated future returns and elevated future risks. These prospects have pushed us to gradually reduce our market risk, until there was no risk left to reduce.

Markets can certainly go higher from here.  In fact, markets generally have some room to the upside once we move to a 100% cash target. But they also tend to fall eventually – and they often fall dramatically.  Though we may miss out on intermediate gains, we are taking a longer-term perspective.  Following the 1997-98 move to 100% cash, markets were able to rise dramatically into the tech-bubble peak while this strategy watched largely from the sidelines. By the end of the tech bubble collapse five years later, the S&P 500 (dividends included) found itself lower, while Time Overlay strategies posted significant gains.

We do not anticipate a repeat of the tech bubble crash, but the past performance is a strong reminder that missing out on gains temporarily does not necessarily mean missing out on gains permanently. The last three times our core strategy has targeted a full cash allocation, it has resumed buying within 1-8 months, and there is no reason to expect this cycle to be different.

Though we are taking an extremely cautious positioning, we do not need an extreme move to increase our equity allocation.  We are merely waiting for a high-probability entry point. We see no such opportunity today. 

Our contrarian approach generally dictates that we prefer to align ourselves with corporate insiders and not the more speculative class of retail investors.  But the last few months have been driven by record-setting euphoric and speculative retail activity. 

The first quarter brought unprecedented amounts of speculative call option buying.  According to Bank of America, we have seen more money flow into equity funds in the last five months than we had seen in the previous 12 years.  Using Lipper’s data, we have seen nine consecutive weeks of inflows (the most since at least 2013). Sentiment surveys and allocation data show retail investors are their most bullish since early 2018. Household and non-profit equity allocation is at an all-time high. There is also no shortage of anecdotal tales of speculation in meme-stocks, Bitcoin, non-fungible tokens, and speculative equities such as the Ark Invest suite of ETFs. 

Corporate insiders, meanwhile, have demonstrated minimal enthusiasm about buying, while posting several spikes of excess selling since November.

Despite the new highs for the S&P 500, there have been some signs of market weakness.  After a 10% correction, the Nasdaq is still below its February High (at the time of this writing).  The Russell 2000, which had its own, separate, 10% correction, is further from its high. 

This could be a healthy rotation, but it could also be a sign of a topping market.  Pullbacks in the last few years have been marked by rapid crashes/corrections from highs, but historically, markets have tended to experience a more prolonged topping process. If we look back to 2000 (an analogy that is rightfully getting used more), leadership (tech stocks) peaked well ahead of the rest of the market.  In recent weeks, the laggards have come from the previous momentum leaders (TSLA, ARKK, SPACs and IPOs).

Beyond momentum and speculation, there are fundamental reasons markets could continue to rise: namely, massive monetary and fiscal stimulus.  In the past year, congress has passed stimulus amounting to over 25% of GDP.  Interest rates are historically low, and the increasingly dovish Fed has promised to keep the Fed Funds rate at 0% until inflation is sustainably above 2%. Large-scale combined monetary and fiscal stimulus has always fueled massive bull markets.  This time was no different, but there is a limit to how far beyond norms these cycles can go, particularly without commensurate underlying growth.

That leaves the question of growth. Many market optimists are encouraged by massive earnings and GDP growth forecasts.  We are not denying that the rebound from COVID has been, and will continue to be, exceptionally strong, but there is significant uncertainty that the market simply is not pricing in.  Quarterly earnings are back at a new all-time high, but it remains to be seen how much of that growth is organic/sustainable versus pent-up demand combined with stimulus payments.  We have yet to eclipse 2019’s full-year earnings, but investors are paying nearly 30 times those profits.  That is far above any historically sustainable level – a more than 20% premium to the multiples at the start of 2018 (when we had strong organic growth combined with massive corporate tax cuts).  The only time stocks were ever this expensive: the end of 1998 through the tech bubble peak, preceding a lost decade which saw stocks fall 50% twice.  It is worth noting that many other popular valuation measures are well-above their tech bubble peak.

Though we believe we have a strong economic recovery ahead of us, there are legitimate concerns that the scarring from the recession is real and will be difficult to shake.  We just received a great jobs report, showing that nearly 1 million jobs were added in March, but almost all of the jobs gained over the last year have been jobs that were viewed as temporary losses to begin with.  If you look at U5 unemployment and exclude the temporarily unemployed, the jobless rate is stuck in the middle of the range it has been in since last June. Weekly initial jobless claims continue to come in at deeply recessionary levels, and the prime-age employment/population ratio is well-below its pre-COVID peak.

Even as we approach normalcy, it is unclear how much of the benefits will process through to corporate earnings of publicly traded companies.  Well-capitalized large businesses were uniquely situated to weather and even capitalize upon the pandemic. Contrarily, the return to normal could certainly see local and small businesses witness the largest benefits.  Companies of all sizes, meanwhile, are watching their input costs rise and finding it difficult to fill jobs – a trend certain to squeeze profit margins, which have been abnormally high in recent years.  Falling margins or disappointment in the magnitude/speed of the recovery could pose a serious threat to this market.

With valuations this elevated, risks remain very high, and without more encouraging data, our strategies will remain extremely conservative.  Global ETF accounts are still holding some equities, and our options-enhanced accounts continue to sell out-of-the-money puts, but we have reduced risk across the board. It is tempting to chase returns wherever they may be found, but that it the type of behavior that often gets investors into trouble.  Paying high prices for equities may come with more potential for gains than sitting in cash in a low-rate environment, but the potential for significant losses is real and increasingly difficult to ignore. In order to make money in the long-run, it is not necessary to take on risk at all times. 

There are times that it has paid to take everything off the table and wait. We believe this is one of those times. Because this is a unique situation for most of our clients, however, we welcome any and all discussion about how our current positioning affects your goals and needs. 

Robert B. Drach

Drach Advisors LLC