The herd instinct is alive and well, judging by the latest Merrill Lynch monthly fund manager survey. In recent months, the percentage of fund managers viewing stocks as overvalued hit record levels. Nevertheless, everyone continued buying anyway; in January, equity allocations hit two-year highs; cash levels touched five-year lows; the number of investors buying downside protection against a correction hit levels last seen in 2013. Of course, stocks then plunged, prompting a sharp about-turn in the latest survey. The percentage of investors buying protection against a "sharp" market fall soared, recording its biggest one-month jump on record. Equity allocations suffered their biggest monthly fall in two years. In other words, if others are buying, you must do the same, even if stocks are overvalued. And if others are selling and stocks are plummeting – well, that's just the time to buy downside insurance. Herding behaviour aside, the sentiment change was not sufficient to take Merrill's Bull & Bear Indicator out of "sell" territory. That suggests that in spite of last week's strong market rebound, stocks are likely to retest recent lows.
Montier: stocks are in a
‘cynical bubble’
Investor herding is annoying GMO's James Montier, who sees the Merrill survey as further evidence that stocks are in a "cynical bubble". Montier's latest note describes stocks as "obscenely overvalued", while admitting he has a track record of being too early in calling bubbles. He points to how he turned bearish on Thailand in 1995, two years before the Asian financial crisis; he predicted the technology bubble would burst in 1997, three years before the top; and he was a few years early when warning about the US housing bubble in 2005. The implication is that Montier has a history of being early but correct, which is somewhat disingenuous – he has been bearish on this bull market since at least 2011. Still, there is some validity to his latest complaint about "that strangest of creatures: the fully invested bear". Managers have overweighted equities despite seeing them as plainly overvalued – "a cynical bubble built not on faith in a new era, but on overoptimism about the ability to get out before everyone else". Of course, it's impossible for everyone to get out on time. The speed of the latest correction is proof that "crowded exits don't end well – inevitably some are crushed in the stampede".
Companies are crushing earnings estimates
Amid the ongoing agonising about US inflation and the interest rate outlook, you might not have noticed stocks are enjoying a very fine earnings season. Thus far, 70 per cent cent of companies have beaten analyst estimates, notes
Bespoke Investment
– the best beat rate for more than 10 years. Even better, corporate revenues (which are much trickier to game) have been excellent – 73 per cent of companies have beaten revenue estimates, the best beat rate since 2004.
The figures are additionally impressive in that expectations had been high, with analysts busy hiking forecasts in the run-up to earnings season. Last October, earnings were forecast to rise 11 per cent in 2018; that figure has surged higher to almost 19 per cent today. Of course, much of this is due to US tax cuts, which many view as a token one-off boost. Still, the S&P 500 now trades on 16.5 times estimated earnings, down from 18.5 in January. Clearly, the recent market falls, coupled with surging earnings, mean stocks look noticeably less pricey than they did a few weeks ago.
Good earnings, good stock market? Not necessarily
Bulls will be hoping soaring earnings will drive stocks to fresh highs, but Merrill Lynch data indicates a simplistic “earnings good/markets good” attitude is, well, simplistic. Stocks have declined in 29 of the last 90 years. Of those 29 years, earnings rose almost 70 per cent of the time; double-digit earnings growth was reported almost half of the time. Over the entire period, Merrill notes, less than 20 per cent of the S&P’s annual performance was driven by earnings. Fundamentals account for only so much: sentiment and expectations “are a bigger driver of near-term returns, particularly late in bull markets.”
Stocks upended by volatility trade
The recent upsurge in volatility wasn’t driven by the market plunge, says
Schwab
strategist
Liz Ann Sonders
; rather, the spike in volatility caused equities to plunge. Sonders points to January’s Merrill Lynch fund manager survey, which found the “short volatility” trade was the most crowded trade in financial markets. The unwinding of that trade caused volatility levels to spike artificially high, dragging equity markets down with it. This interpretation is supported by the casual reaction to inflation data last Wednesday. US bond yields hit 2.9 per cent in response but stocks shrugged off the news while volatility, as measured by the Vix index, continued to decline to more normal levels. Sonders reckons the correction is largely over but so too is the era of remarkably low volatility – expect bigger drawdowns and bigger daily moves from now on.
