Q2 2021 Commentary

It was another very quiet quarter for all of our investment strategies.

We entered the quarter with our core domestic strategy 100% allocated to cash and money market funds. Our global strategy was only slightly more aggressive, with an equity allocation closer to 15%.

This was the first time since 1998 that Time Overlay focused accounts were this conservatively positioned. As discussed in our previous comments, this positioning was likely to be relatively brief. As it turns out, it was.

A few accounts initiated a small equity position prior to the end of the quarter, and as of the time of this writing, all domestic accounts have once again resumed buying.

This move may seem somewhat contradictory. After remaining cautious for most of the year – refusing to chase markets higher at historically expensive valuations – we expected that it would take a more significant pullback to lure us off of the sidelines. Instead, we initiated buying the very same weeks that the major indices were setting new record highs.

But what is happening in the headline numbers belies some emerging values within the market.

The S&P 500 lost momentum from late April through mid-June. The index never fell more than 4% from its high, but there was enough weakness among quality names to begin to pique our interest. At the time, we were prepared to buy aggressively if market weakness were to persist or worsen. Instead, the buying opportunity was fleeting – just long enough for us to add exposure.

Since our June 18 “Buy Watch” indication, the major averages have rallied back to new all-time highs. Unlike some other recent rallies, however, this one has left much of the market behind. Indices might be at record highs, but a relatively small percentage of stocks are participating with their own new highs. It has been the largest companies that have carried most of the weight for the latest leg higher. If you analyze the S&P 500 on an equal-weight basis, it has failed to break out from levels first reached in May. If we turn to smaller-cap names, the picture is even weaker, with the Russell 2000 clearly below levels first reached back in February.

This divergence between large and small cap names could break either way. Bulls see the underlying weakness as a rolling correction – allowing markets to rectify some of their excesses without widespread selling. We have seen a few instances of this dynamic during this cycle, each with stocks coalescing to new highs. This possibility is among the reasons we are comfortable increasing our exposure.

But the underlying weakness could be the first sign of a move lower. Declining breadth is seen by many as a warning sign of things to come, and there remains a strong chance that the major indices “catch down” to the rest of the market. As we have discussed at length in past comments, the probabilities are elevated that any such move becomes more severe.

While we believe that the short-term outlook for the market (at least parts of the market) looks better than it did three months ago, the conditions that have driven our long-term concerns have hardly changed.

Corporate earnings have rebounded sharply, far exceeding expectations from just a few months ago. That development has made stocks slightly less expensive on a P/E basis, but much of that rebound was merely a return to pre-pandemic levels. By our preferred valuation metric, Price/Peak Earnings, stocks are only about 4% cheaper than they were three months ago. That keeps U.S. stocks more expensive than all other times outside of a 14-month period near the peak of the tech bubble.

Besides valuations, we remain very weary of still-euphoric investor sentiment. The Investors Intelligence survey just saw its bull:bear ratio approach 4:1 (we view 3:1 as excessively optimistic). The AAII survey of retail investors has had bulls in the plurality for 35 of the last 37 weeks – only the second such stretch since 1987.

The most concerning signs from the public, however, come not from surveys, but from the magnitude of their equity allocations and their continued eagerness to chase markets higher.

One of the more reliable past indicators of long-term market returns has been the percentage of household financial assets committed to equities. That measure last set records near the tech bubble highs, preceding a lost decade. This market has seen allocations rise even higher.

Investors continue to add to those allocations, buying aggressively at very high prices. According to Bank of America, flows into equity funds have already hit levels that would set a one-year record high, even though we are only half-way through the year. Considering the massive flows into more speculative assets such as cryptocurrencies, it is hard to make an argument that this is not a bubbly environment.

In regard to all of the above data, it is worth circling back to our justification for our limited foray into the market at this point. Despite record flows year-to-date, fund flows have actually been slightly negative over the last several weeks. It is also worth noting that, despite high market valuations, the names we have been buying trade at a steep discount (~40%+) to the market – representing attractive relative value. Of course, we continue to hold a very large cash allocation across strategies.

That said, the general stalling of the market and the internal divergences have the potential to create an environment that could see us enter the market rather swiftly. Our strategies have bought heavily in late-stage expensive markets before. After moving to 100% cash in 1998, Time Overlay bought heavily in late 1998 and early 2000. The strategy maintained some equity allocation throughout the tech bubble crash with considerable success. We will not be completely averse to investing in expensive, euphoria-laden markets, but we will make sure we are careful and prudent when we do so.