A few weeks back a well-respected and prominent hedge fund manager made the following comment on live TV at the World Economic Forum in Davos, Switzerland. The press ate it up.
"We are in this Goldilocks period right now. Inflation isn't a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax laws... the market will be inundated with cash... [there is] a lot of cash on the sidelines... If you're holding cash, you're going to feel pretty stupid".
Within a week of that comment, stocks around the world tanked. The decline in U.S. stocks that started on January 29 was the sharpest 10% correction from all-time highs in history. It took just 9 days. As we touched on in Bubbles, Bonds & Diversification, because higher interest rates were the "trigger" (an oversimplification) for the sell-off, everything with inherent interest rate risk got hit.
The impact on several key markets during the decline is shown below. (Markets have since partially recovered from these levels.)
Assets that perform best when interest rates are low and stable took it on the chin, while cash did exactly what it was supposed to do, which is nothing.
The 9-day sell off was punctuated by a massive reversal of flows into and out of stock and cash proxy exchange-traded funds (ETFs), respectively. The chart below shows fund flows into the largest stock ETF (SPY) and a popular cash substitute (BIL) over the last 52 weeks. The majority of the reversal happened very near the low point of the sell-off. Including all mutual funds and ETFs, a total of $46 billion was pulled out of the market in just the first six trading days of February. (Flow data below is from Morningstar.)
This reversal is particularly interesting when viewed alongside monthly flows over the last several years. We are using SPY as a proxy for stock ETF flows, but including broader equity flows makes the point even more acute. According to Bank of America, in the 4 weeks leading up to January 19th, investors ploughed $58 billion into stock funds, the "fastest surge ever". In their view, the motivation was FOMO (“fear of missing out”).
According to TDAmeritrade and Schwab, immediately prior to the decline retail investors had the highest allocations to stocks and lowest allocations to cash they had ever recorded. All of this suggests investors went all-in only to get their wrists slapped.
This immediately showed up in sentiment measures, which were at the highest levels we've ever seen leading up to the decline. The chart below is a composite of several retail and institutional sentiment measures we track.
A group of market participants that do hold large cash reserve are corporations and it looks like they put it to work via buybacks. While many have not reported earnings yet and are therefore still in the buyback black-out periods before announcements, corporate-trading desks were inundated with buyback orders during the decline.
Soon after all of this, our prominent hedge fund manager posted his updated thoughts on LinkedIn:
"To be clear, I’m not claiming to be smart about this. In fact, the opposite is true, as this is happening sooner than I expected. Still, these big declines are just minor corrections in the scope of things, there is a lot of cash on the side to buy on the break, and what comes next will be most important."
We haven't mentioned the quotes above to criticize the guy. He's made enough good calls for all of us and at least he admitted things had deteriorated sooner than he expected. His firm was also quietly amassing a monstrous short (perhaps as high as $22 billion on a gross basis) position in European stocks while all this was going on so he may have just been "talking his book".
His comment that this decline is minor in the larger scope is of course also true. The recent decline viewed against a very long-term chart of stocks is almost invisible.
So why do we care? We found his comments interesting for two reasons. First, because his earlier comments captured the prevailing mood of investors, especially those in the U.S. People were hyper bulled up about the economy and the stock market. And for good reason. Tax cuts, earnings revisions, stable inflation, a possible infrastructure plan and a host of other factors created the exact goldilocks environment he discussed.
Everything was awesome!
The problem was (and maybe still is) that most everyone understood that. Prices reflected that widespread optimism, leaving little room for positive surprises. That's how cycles stall out or even end. We don't know if that's the case here, but what comes next will be most important (as he pointed out).
The decline we just witnessed may be less interesting in a normal year, but given it happened after a euphoric run-up in prices that occurred alongside some of the highest consumer and investor sentiment readings in history, raises the stakes.
Sentiment numbers have come down a little over the last week, but not by much. Also, something else has happened that we think is peculiar. Rather than the usual media circus telling everyone why they should freak out and prices subsequently rising defiantly in spite of that, this happened:
If a hallmark of bull markets is their ability to "climb a wall of worry" (worried investors today are a source of future demand for stocks), not many people seem worried right now... and that has us a little worried.
We continue to recommend holding at least some cash. We put a some of the additional cash we raised at the end of January to work last week, but we couldn't find a whole lot to get excited about. These small changes were all in the context of broadly diversified portfolios that still hold some stocks.
As asset allocators, we wouldn't mind a little more of a panic; panics can be a great opportunity to put cash to work, but we would feel more comfortable doing that if everyone wasn't falling over themselves to tell us what a great opportunity it was to buy stocks.
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