December 2020

A long term history of the market shows that qualitatively the biggest drawdowns tend to occur when the market is euphoric, not fearful.

In this note we demonstrate why we see this market as somewhat complacent, and how this will be our biggest risk factor heading into 2021.

This does not detract from obvious positive market catalysts, such as vaccines, earnings upgrades, sky high iron ore prices, which are precisely the reason we should be both positive but yet at the same time conscious that a turn in sentiment would mean significant drop.

A fall in sentiment of this nature, the catalyst of which could and if it does occur likely will be a total left field event, is something we are actively protecting our portfolio against. We would discourage investors from putting all their eggs in the equity basket, and remaining diversified, for this precise reason.

Living with a Bi-Polar Market

This is something of a subjective and objective assessment.

In pathologizing the aggregate psychological condition of the market after a tumultuous year, one word springs to mind: bipolar. Bipolar describes fluctuations between two poles or states of extreme highs and extreme lows.

A bipolar state of the market is difficult to forecast, capable as it is of bouts of euphoric mania followed by periods of depressive hopelessness.

These sentiment swings have been especially acute over 2020, and explain a great deal of the return differences across stocks, manager returns, or asset classes.

Below is Resonant Asset Management internal indicator of risk sentiment in Australian Equities – a similar story can be found in other markets, even more acutely in the US.

What this demonstrates is the extraordinary lift in risk sentiment over the last 6 months, and given this indicator is typically mean-reverting, why we see this as an unsustainable contributor to stock prices going forwards.

Figure 1 below: Resonant Asset Management Risk Sentiment Indicator in Australian Equities. As indicator rises, investors are more incrementally more comfortable taking risk. This is typically mean reverting over long periods. (Source: Resonant Asset Management, Refinitiv)

Another indicator to use to gauge the euphoria of the market is to look at equity issuance. We can do this on the S&P 500 index by looking at a ratio of the market cap by the index level – if this quantity increases, then issuance is rising, and vice versa.

While this indicator is just at its nascent stage of a pick-up, this is undoubtedly a step change from the previous period, and since 2010, where companies have been buying back shares in aggregate.

Raisings are a net negative, as the Earnings per Share of existing shareholders falls as the share count increases.

In aggregate, 2.5% of the US market cap has been issued as additional stock on a net basis (subtracting buy-backs) over the last six months, countering any expected earnings growth on a per share basis.

Figure 2 below: net stock issuance on a rolling 6 month basis as a percentage of market cap, note this is a clean break from nearly 10 years of net buy backs. (Source: Resonant Asset Management, Refinitiv)

Guarding Against a Sentiment Swing

The bigger challenge in today’s financial markets is finding reasonably priced hedges.

With global sovereign 10 year bond yields at sub 1%, the struggle is finding reasonable priced hedges for portfolios with genuine negative correlations with equity markets and other growth assets.

Fortunately this market euphoria does yield some opportunities to pick up some reasonable priced hedges.

Hedge #1: Gold Miners and Other Uncorrelated Corners of the Equities Market

The Australian Equities market offers some unique uncorrelated exposures. Chief among them are the Gold sector, but there are others. They offer unique properties for multi-asset investors looking to hedge growth assets.

Regardless of the measure we use we see significant value in Gold Mining stocks. They have been violently sold off by short term macro traders rotating portfolios for a cyclical recovery. In their wake the traders leave companies trading on double digit free-cashflow yields. Exacerbating their misery is Bitcoin, which now seeks to test the $20k USD high from 2017 once again.

And now, the average stock in the sector is approaching valuation levels historically correlated with future outperformance.

In fact the valuation currently is associated with a historical outperformance of over 20% on a 12 month forward basis (see figure below, blue bars (LHS) is the Resonant proprietary valuation signal for ASX Gold Miners, versus orange line (RHS) subsequent 12 month total return).

Figure 3 below: Resonant Asset Management’s proprietary ASX Gold Miners Valuation model score (blue bars, left hand scale) versus forward 12m price return (orange line, right hand scale) – sector is currently undervalued to the extent it was in 2014 and 2016. (Source: Resonant Asset Management, Refinitiv, S&P)

Hedge #2: Use the ETF ILB

The iShares ETF ILB could see significant inflows in 2021.

The removal of a great deal of demand, followed by its re-instating, has caused consternation for suppliers in all economies in 2021.

The pent up demand unleashed looks quite plausibly to create an inflation spike, albeit temporary, next year or in 2022.

Inflation tends to lag the real economy, but we will see the market price inflation before official statistics suggest so.

As a reminder, ILB pay quarterly coupons linked to official releases of SPI from the ABS. This means that, should inflation expectations increase, investors will buy ILB in the expectation that the income on this product will increase.

The more persistent the perceived rise in CPI, the more likely the investor is to see fair value in this ETF.

We suggest a portion of Fixed Income portfolios should be exposed to ILB, as under this scenario, it will provide better hedging than the fixed and inflexible nominal government bond.
It will still benefit from an extended QE program, which drives down real yields. It is in fact perfectly aligned with the goals of the RBAs stated position, which is that employment is to be prioritized over inflation – ie. Inflation will be allowed to run without rising rates if employment is above a long term objective (probably around 5%).

Hedge #3: Start to Build an Alternatives Exposure

This goes beyond the scope of this particular note, but we feel that a return of volatility and the struggle to find well priced effective hedges should play in the hands of hedge fund managers.

Selectivity however is key in this space.

Investors can no longer be satisfied with paying hefty fees for trend following strategies, which are effectively automated and don’t provide the desired diversification at market turning points.

The overall balance of a combined suite of alternatives can however shield the portfolio through tough markets, particularly if they are able to effectively and skillfully employ derivative strategies, which are beyond the scope of many investor portfolios.