Submitted by Vanda Research Group
Hippocrates Sleve
In his most recent Sunday note entitled “The Stock Market Doctor“, Morgan Stanley equity strategist Adam Parker writes that:
‘The main questions investors ask us today seem to be about the exterior appearance of the market and not fundamentals. “What is this price action telling you?” “What are other investors asking you about?” “How are other people positioned?” Or, “what’s the current sentiment?” ‘
Parker goes on to bemoan this recent hyper-focus on positioning and sentiment, arguing that clients should instead be asking more “fundamental” questions like:
‘Which areas of the market may show accelerating growth in cash flows? What is the future value of all cash flows discounted back to the present? How have your assumptions about growth or rates changed recently?
With all due respect to our former employer, we couldn’t disagree more. Positioning, sentiment and all of those other behavioral nuances that the sellside historically doesn’t like to dirty their hands with are hugely important to returns, especially in the short-to-medium term.
That isn’t just the case today. That’s been true for a long, long time; and certainly since the crisis. If share prices are a function of a fundamental factor (earnings, cash flows, etc) multiplied by a behavioral one (price multiples), then the latter is significantly more important for returns over a twelve month horizon. The three charts below graph the YoY change in share prices, P/E multiples and consensus EPS estimates for the three largest sectors in the S&P – tech, financials and healthcare. If the goal is to forecast the orange line, we’d much rather spend our time trying to predict the purple line (P/E) rather than the blue one (earnings).
World philosophies aside, investors are asking about positioning and sentiment because being a contrarian matters even more in an environment that lacks clear market directionality or momentum (like the one we’re in now).
In that respect, here’s our attempt at answering the questions that Morgan Stanley won’t:
- “What is this price action telling you?” That it’s all about (a dovish) Yellen. We can’t stress enough how unusual it is for equities to rally as strongly as they have for the past two months whilst the cyclical/defensive ratio remains flat (chart below). Risk is being propelled almost exclusively by a dovish Fed, and it’s not until cyclicals begin outperforming that we’d grow more confident about the underpinnings of this current rally.
- “What are other investors asking you about?” When do base effects start kicking in for inflation this year and how important are they (Sept/Oct, and minimal influence). When is it safe to get back into China (now). What are your favorite idiosyncratic trades (long DAX vs FTSE vol trades, long NKY / short SPX vol trades). What’s your favorite way to play an upside breakout (short Dec16 Fed funds futures).
- “How are other people positioned?” Long duration and anything that looks like safe yield, defensive equities for example. Getting more positive on EM, but still underweight. Still really short Japanese equities. Most continue to hold a surprisingly high amount of cash in spite of last month’s rally. They’re using options premium for any exposure, cash is so last year.
- “What’s the current sentiment?” Bearish and skeptical of rallies (both present and future). Most HF clients will keep net and gross exposures low for the rest of the first half – regardless of what happens on the macro front. Understandably, most managers will stay in business-protection-rather than performance-mode.
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