An unquenchable thirst for yield has been a major trend among investors over the past two decades. Rapidly aging populations and the steadily declining yields offered by high-grade bonds have motivated income-seeking investors to seek shelter in equity dividends.
Treasury bonds currently offer negative real yields while challenges to earnings growth promise to handicap dividend increases by stocks for many years.
The 5 biggest companies in the S&P recently reached a combined weighting of almost 23%, much greater than the similar measure at the peak of the internet bubble or the previous high in 1980.
As we have commented previously, the current market concentration is a reflection of the pervasive influence of the internet on the economy as well as the popularity of passive investment strategies which serves to drive capital into the highest market weight stocks.
The monetary and fiscal induced market rally since March 2020 has been remarkable in many ways, not least the amount of capital that has been directed to global equities in 2020, but especially 2021.
There were sound reasons for stock markets to begin to rally last March. Stocks were oversold, and the various stimulus efforts provided a tailwind.
The valuation premium of US large-cap stocks has reached levels last seen during the internet, which may provide a clue to where we are in the market cycle.
Major bull markets are typically driven by a small number of stocks that represent an important technological development. The current market is driven by the FAANG+Microsoft group which is the product of the internet-related companies that drove the previous market.
This trend in market leadership is apparent throughout history. The bull market that preceded the 1929 market top was led by radio stocks. …
Extremes of investor sentiment, whether bullish or bearish, have proven to be a valuable tool for identifying periods with a high probability of major trend changes.
Indeed, one of the most reliably profitable strategies through time has been to adopt an investment position counter to these extremes of crowd behaviour. It is not practiced often because it is psychologically demanding. Human beings have exhibited a strong tendency to adapt their behaviour to consensus thought through history.
S&P 500 short interest has declined to all-time lows and now rests at levels last seen at the peak of the internet bubble era.
The low short interest level attests to the pervasively bullish view currently held by both institutional and retail investors. Such extremes of sentiment have proven to be a reliable indicator of elevated market risk.
As well, the low current levels will diminish the effect of short-covering rallies, which typically act as a brake on sharp market corrections as short sellers close their positions to harvest their profits.
One of the many psychological traps that produce investor complacency, such as we are seeing in today’s markets, is called recency bias. It is the tendency to believe that recent events can be extrapolated into the future.
Times of generally rising markets cultivate investor complacency by instilling the belief that “buy-and-hold” and “buy-the-dip” strategies can be safely implemented.
Part of the appeal of these strategies is that they are intellectually undemanding, requiring little thought of current market conditions or prospects.
Small Companies Play An Important Role In The Economy And Markets.
The trend since 2007 of capital outflows from US small-cap funds has worrying short- and long-term implications.
Of more immediate concern is the divergence of fund flows and the Russell 2000 small-cap index. Since 2007 periods of significant capital outflows from small-cap funds have either preceded or coincided with sharp declines in the Russell 2000 and broad market indices. We are currently experiencing the greatest divergence between capital flows and the Russell 2000 since 2007, which does not bode well for the near-term prospects for stock markets.
The appetite of Americans to embrace financial risk ended the first half of 2021 at all-time highs, and has only increased since then with the rising market.
A popular argument to support such risks is the current historically low level of interest rates, which we find less than persuasive.
Investor psychology is fragile, and there is a host of potential catalysts for market volatility. The rate of interest on margin loans will matter little to investors incurring substantial losses during a correction or bear market.
CAN PAYING ATTENTION TO MAGAZINE COVERS MAKE US BETTER INVESTORS?
Identifying extremes of investor sentiment (and then taking a contrary position) has proven to be one of the most reliable techniques to generate superior long-term investment returns.
A useful gauge of sentiment has proven to be the subject of popular magazine covers, as they tend to reflect consensus opinion. Magazine covers have historically proven to be harbingers of investment trend changes, with the most famous example being the “Death Of Equities: How Inflation Is Destroying The Stock Market” cover of the August 13, 1979 issue of Business Week.